Handout 6: The Mundell- Fleming Model

Question 1

What is the Marshall Lerner Condition?

Answer 1

The condition says that starting from a situation of a balanced current account: a real depreciation:

• will improve the current account if the sum of the two elasticities is greater than one
• will deteriorate the current account if the sum of the two elasticities is smaller than one.
• will have no effect on the current account if the sum of the two elasticities is equal to one.

If the Marshall Lerner condition holds, the volume effect dominates the price effect.

Question 2

Does the ML condition hold in the short run?

Answer 2

No, the price effect dominates the volume effect leading to a deterioration of the current account following a real depreciation of the exchange rate.

Question 3

Does the ML condition hold in the long run?

Answer 3

It might hold in the long run.

Question 4

What are the assumptions of the Mundell- Fleming Model?

Answer 4

• AS curve is flat which implies, P’s are fixed, the AD curve determined the level of economic activity.
• We concentrate on the demand side of the economy only (IS-LM curves).
• The current account is determined independently of the capital account.
• The current account: PPP does not hold, even in the long run, and the size of the current account surplus depends positively on the (real) exchange rate and negatively on (real) income.
• the capital account: the role of interest rates is central to the model.
  1). Exchange rate expectations are static.
  2). Capital Mobility:
  If perfect capital mobility, then the UIRP condition always holds and given that expectations are static: r=r*
• If imperfect capital mobility flows of capital depend on interest rate differentials between countries. K = K(r-r*)
• The balance of payments is given by:
  CA (y,e) + K (r - r*) = 0.

Question 5

What occurs when there is a monetary expansion under floating exchange rates and imperfect capital mobility?

Answer 5

• Depreciation of the nominal exchange rate
• Increase in the level of income
• A fall in the real interest rate
• An improvement in the current account of the balance of payments.

Question 6

What occurs when there is a monetary expansion under floating exchange rates and perfect capital mobility?

Answer 6

• Depreciation of the nominal exchange rate
• Increase in the level of income.
• No change in the real interest rate.
• No change in the current account of the balance of payments.

Question 7

What happens when there is a fiscal expansion under floating exchange rates and imperfect capital mobility?

Answer 7

• Appreciation of the nominal exchange rate
• Increase in the level of income.
• A rise in the real interest rate.
  A deterioration in the current account of the balance of payments.

With perfect capital mobility, the IS curve will move only temporarily. All the adjustment will take place through the excahnge rate, so that in the end, the expansionary effect of public spending is completely offset. No impact on output (crowding out is complete).

Question 8

Monetary expansion under fixed exchange rates and imperfect capital mobility

Answer 8

• In the short run, if capital is not completely mobile, the real interest rate decreases, income increases so both the current account and the capital account (so the balance of payments as well) deteriorate).
• In the long run, given that the exchange rate is fixed, the Central Bank intervenes and decreases its reserves up to the point where output and the rael interest are back to their previous level (and where the balance of payments is back in equilibrium).
  In the new equilibrium, the only difference is in the composition of the money stock (less reserves and more domestic credit).