Mundell - Fleming model Flashcards
asset market equilibrium equation (LM)
M/P = kY − hi
Where:
M/p= real money supply
k= income elasticity of money demand
Y= output
h= interest sensitivity of money demand
i= interest rate
consumption function
Consumption(C)=cY
Where:
c= marginal propensity to consume
Y= output
investment function
I = ̄I(bar) − bi
where:
I = investment
I(bar) = autonomous investment
b = interest sensitivity of investment
i= interest rate
export (EX) function
EX = x1YW + x2 R
Where:
EX = exports
x1= marginal propensity to export
YW= foreign economy output
x2= exchange rate sensitivity of exports
R= exchange rate
Import (IM) function
IM = m1Y − m2 R
Where:
IM= imports
m1 = marginal propensity to import
Y = National income
m2 = exchange rate sensitivity of imports
R = exchange rate
FE curve function (Balance of payments)
BP ≡ CA + CP
Where:
BP = Balance of payments
CA = current account
CP = capital account
Current account function (CA)
CA = NX = EX - IM
Capital Account funtion (CP)
CP = κ(i − iW )
CP = capital account
k= rate capital mobility
i = interest rate
iw= world interest rate
Keynesian function
Output (Y)= Aggregate expenditure (AE)
IS curve function
Y=C+I+G+EX-IM
Mundell-Fleming model limitations
- Fixed prices: The assumption of fixed prices and therefore zero inflation in the Mundell-Fleming model is in the short run and can limit policy effectiveness.
- Lack of government budget constraint: The model doesn’t consider government budget constraints or their impact on monetary policy.
- Lack of welfare metric: The model lacks a welfare metric to evaluate policy impact on individuals, focusing solely on macroeconomic aggregates.
- Endogenous money: the model assumes the money supply is exogenous but in reality, it’s endogenous, impacted by bank lending decisions that affect policy effectiveness.
fixed prices limitation critical assessment
- simplified analysis allowing us to easily build a model which gives us clear policy analysis
- Allows us to represent the LM and IS curves in the same space as the nominal and real interest rates are the same with zero inflation. otherwise we can compare asset returns using the nominal interest rate when constructing the LM curve, but when analysing investment decisions we should use the real interest rate
- The zero inflation assumption isn’t a major drawback in economies like the US or UK as inflation is typically close to zero
- The Mundell-Fleming model is principally used for short run policy analysis so long term inflationary consequences can be placed aside
Lack of government budget limitation critical assessment
- can include this constraint for funding through current taxation
- Ricardian equivalence (people adjust their spending in anticipation of future taxation)
- in practice most households don’t act so logically
- considerable theoretical work has been put into micro-founded models that have such a constraint. The major drawback of those models - aside from their complexity - is their inability to admit a positive role for fiscal policy, particularly in recession scenarios.
Lack of welfare metric limitation critical assessment
- Mundell-Fleming model assumes rise in GDP is a rise in welfare as it is a macro founded model that doesn’t take individual households into account
- There are micro founded models which take individual households into consideration but they have the draw backs of being considerably more complex and tend to assume all households are identical so they can aggregate to the macro level
- There is no reason to believe that a macro economic system is any better represented by a micro aggregation than by a macro level model
endogenous money limitation critical assessment
- some argue that as central banks set interest rates that the LM curve can be replaced by a horizontal monetary policy (MP) curve
- however in every market there is a price-quantity pairing
-so behind every MP curve (price) there is an LM curve (quantity)
