Mundell–Fleming model
The Mundell–Fleming model has been used to argue[3] that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy.
In contrast, under fixed exchange rates e is exogenous and the balance of payments surplus is determined by the model.
Under both types of exchange rate regime, the nominal domestic money supply M is exogenous, but for different reasons.
Under flexible exchange rates, the nominal money supply is completely under the control of the central bank.
As explained below, whether domestic monetary or fiscal policy is potent, in the sense of having an effect on real GDP, depends on the exchange rate regime.
An increase in the global interest rate shifts the BoP curve upward and causes capital flows out of the local economy.
Under less than perfect capital mobility, the depreciated exchange rate shifts the BoP curve somewhat back down.
Under perfect capital mobility, the BoP curve is always horizontal at the level of the world interest rate.
Thus net payments flows into or out of the country need not equal zero; the exchange rate e is exogenously given, while the variable BoP is endogenous.
In the very short run the money supply is normally predetermined by the past history of international payments flows.
To maintain the exchange rate and eliminate pressure on it, the monetary authority purchases foreign currency using domestic funds in order to shift the LM curve to the right.
If the global interest rate increases, shifting the BoP curve upward, capital flows out to take advantage of the opportunity.
Once again, the LM curve plays a passive role, and the outcomes are determined by the IS-BoP interaction.
Results for a large open economy, on the other hand, can be consistent with those predicted by the IS-LM model.
In particular, it may not face perfect capital mobility, thus allowing internal policy measures to affect the domestic interest rate, and it may be able to sterilize balance-of-payments-induced changes in the money supply (as discussed above).
Under the Mundell–Fleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply (by international funds flows).
The Mundell–Fleming model applied to a small open economy facing perfect capital mobility, in which the domestic interest rate is exogenously determined by the world interest rate, shows stark differences from the closed economy model.
In the closed economy model, if the central bank expands the money supply the LM curve shifts out, and as a result income goes up and the domestic interest rate goes down.
But in the Mundell–Fleming open economy model with perfect capital mobility, monetary policy becomes ineffective.
An expansionary monetary policy resulting in an incipient outward shift of the LM curve would make capital flow out of the economy.
The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the LM curve to shift to the right, and the interest rate remains equal to the world rate of interest.
He adds that, in the short run, fiscal policy works because it raises interest rates and the velocity of money.
(ii) A limited banknote supply based on a fixed relationship to the gold reserve.
(iv) Control of interest rates and a balanced budget in order to reduce the national debt.
The loss of control of interest rates and serious economic crisis every ten years (1847, 1857, 1866) is consistent with this analysis.
