Mundell Fleming

Question 1

What are the assumption of Mundell Fleming Model?

Answer 1

Model is based on Keynesian tradition, economy is driven by Aggregate demand.

1. Aggregate Supply Curve is flat
2. PPP does not hold, even in the long run. Instead, the size of the current account surplus depends positively on the (real) exchange rate and negatively on (real) income.
3. Exchange Rate Expectations are static
4. Capital Mobility is less than perfect

Question 2

Compare and contrast Mundell Fleming and Monetary Model

Answer 2

Price level
in monetary model, AS vertical, perfectly flexible price level moves to clear money and goods market.
in M-F model, price level is exogenous, no role at all

Income
Monetary model - changes in real income are exogenous, the implication is consumption depends on interest rate not income. Income only plays role to determine demand for real money balance. Exogenous income increase lead to monay demand increase => appreciation of DC.

in M-F model, income is endogenous.
rise in income increases demand for money, leading rise in interest rates, also
rise in income feeds into consumption, hence demand for goods and services increases.
rise in income worsens CA, either through loss of reserves or DC depreciation.

Expectations and exchange rate
Monetary model assumes real interest rate is determined in savings market only, and together with IRP implies nominal interest rates cant clear money markets, Because prices do that job ( r is tied to r*)

in M-F model
goods market equilibrium depends on IS LM free fluctuation. Instead UIRP we have, r=r*+expected S change + risk premium
the shortcoming is monetary or fiscal expansion leaves expectation unchanged, which is problematic

Question 3

Briefly explain how the degree of international capital mobility affects your considerations in M-F model

Answer 3

Floating exchange regime
If perfect capital mobility held (flat BP line), monetary expansion would have maximum expansionary impact on aggregate demand

Fixed exchange regime
If perfect capital mobility holds, any fall in interest rates is rules out, since this would cause immediate run on FX reserves => adjustment would be instantaneous, with newly generated money flowing out of the domestic economy

Question 4

Monetary expansion M-F model floating regime

Answer 4

1. LM curve shifts to right, the new IS-LM is not equilibrium why? because

r (-) => Capital inflow (-)
Ms (+) => higher economic activity

these 2 clearly indicates BoP is deteriorated
In order to restore BoP, S must depreciatein other words must increase
How IS curve shift to the right?
S(+) means better competitiveness=> foreign demand increase => IS shifts right to IS1 and this pushes back the interest rate back towards r0 just until CA surplus can cover capital outflow. that means BoP ie external sector is in equilibrium