Mundell-Fleming Research Articles

Fiscal Policy and Current Account Dynamics in the Case of Pakistan

The relationship between fiscal policy and the current account has long attracted interest among academic economists and policymakers after introduction of the standard intertemporal model of the current account by Sachs (1981) and its extension by Obstfeld and Rogoff, (1995) in open economy macroeconomics. There are two major strands of the current account literature Mundell-Fleming [Mundell (1968) and Fleming (1967)] and Ricardian equivalence [Barro (1974, 1989)] to explain such variations in the deficits. According to Mundell-Fleming model budget deficits cause current account deficits through stimulating income growth or exchange rate appreciation [Darrat (1988); Abell (1990); Bachman (1992) and Bahmani-Oskooee (1992)]. On the other hand, there is Ricardian view that the financing of budget deficits, either through reduced taxes or by issuing bond does not alter present value wealth of private households since both temporarily reduced taxes and issuance of bonds represent future tax liabilities [Kaufmann, et al. (2002); Evans (1989); Miller and Russek (1989); Enders and Lee (1990) and Kim (1995)]. The underlying reason is that the effects of fiscal deficits on the current account depend on the nature of the fiscal imbalance. For example, in a simple theoretical model in which Ricardian equivalence holds, a cut in lump sum taxes and the ensuing fiscal deficit would not affect the current account as the private savings increase will offset the fiscal deficit but investment will be unchanged. Conversely, a transitory increase in government spending will increase both the fiscal deficit and the current account deficit, a case of twin deficits. And a permanent increase in government spending will have no effects on the current account while its effects on the fiscal balance will depend on whether the extra spending is financed right away with taxes (in which case the fiscal balance is unchanged) or whether it is financed with debt (future taxes) in which case the fiscal balance worsens. Thus, fiscal deficit may or may not lead to current account deficits depending on the nature and persistence of the fiscal shock. There is also a third scenario relate to Recardian view that portrays the possibility of negative relationship between the deficits where, for example, output shock give rise to endogenous movements and two deficits are divergent.

Analysis of the Coordination of International Policies Based on the Mundell-Fleming Model

IS-LM-BP model is the model of the interior and exterior double-imbalance state linking the interior economywith the international market in the opening economy. By applying the IS-LM-BP model in the economies oftwo economic entities, the international coordination effect of the opening economy macro policies are analyzedbased on the view of the IS-LM-BP model, and the positive interaction of the macro policy internationalcoordination between the China in the double imbalance with the interior stagnancy and the exterior surplus andthe developed economic entity in the double imbalance with interior stagnancy and the exterior trade deficit inthe global economic crisis is summarized and analyzed, and accordingly the short-term, middle-term, andlong-term macro polices are suggested for China to realize the stable development of macro economy in thepost-financial crisis.

Analysis of movements in the AUD/USD exchange rate: comparison of four major models

Four different models are considered in examining the movements in the AUD/USD exchange rate. Based on the value of R 2, the uncovered interest parity model performs best, followed by the purchasing power parity model, the monetary model, and the Mundell–Fleming model. The opposite signs of the relative interest rate in the uncovered interest parity model and the monetary model and the insignificant coefficient of the domestic interest rate in the Mundell–Fleming model suggest that more study is needed to examine the behaviour of exchange rate fluctuations for the Australian dollar.

A Logical Inference and Extension of the Mundell-Fleming Model

Even though the New Open Economy Macroeconomics models dominate current research trend, the Mundell-Fleming model still shines for its theoretical importance and empirical relevance, and retains its status as one of the workhorse models of international economics. A full grasp of this model is challenging as it covers a wide range of scenarios featuring different exchange rate regimes and various degrees of capital mobility. This paper proposes a logical inference method for studying this model, based on a minor modification of one of its key equations. This method allows one to logically infer the impact effect on the IS, LM and BP curves caused by monetary or fiscal policy moves in each of the contexts, and the subsequent dynamics of the three curves. A simple extension of the monetary equilibrium condition along the same line of thoughts makes the model applicable to analyzing the effects of innovative ways of sterilized foreign exchange intervention.

Effects of Economic Policy Under Capital Controls

This note provides students with a basic understanding of the Mundell-Fleming model, also known as the IS-LM-BP model. The model is useful in understanding the effects of capital controls (typically in a fixed currency exchange rate regime) on a country’s macroeconomic variables. It enables the determination of equilibrium income and how this income responds to economic policy and shocks. It merges the foreign exchange market (BP curve), the goods market (IS curve) and the money market (LM curve).

Canada and the IMF: Trailblazer or Prodigal Son?

Canada played an important role in the establishment of the IMF, yet in 1950 it was also the first major member to abandon the Bretton Woods par-value system in favour of a flexible exchange rate. Canada’s trail-blazing experience demonstrated that a flexible exchange rate can operate in stable and effective manner under a high degree of capital mobility. Equally important, it showed that monetary policy needs to be conducted differently under a flexible exchange rate and capital mobility. In 1962, Canada returned to the Bretton Woods system as a “prodigal son”, after a period of controversial monetary policy. This paper critically analyzes the interaction between Canadian and IMF officials regarding Canada’s exchange rate policy in view of the economic circumstances and the prevailing wisdom at the time. It also examines the impact on IMF research and policy because the Canadian experience influenced the work of Robert Mundell and Marcus Fleming, resulting in the development of the Mundell-Fleming model. Thus, the Canadian floating rate experience not only had important implications for the IMF and the Bretton Woods system, but also for macroeconomic theory and policy in open economies.

DAMPAK KEBIJAKAN FISKAL DAN MONETER DALAM PEREKONOMIAN INDONESIA: APLIKASI MODEL MUNDELL-FLEMING

This study aims to analysis the impact of fiscal and monetary policy in Indonesian economy by using Mundell Fleming (IS-LM-BOP) model. The main objective of this paper is to see the impact of fiscal and monetary policy to Indonesia Gross Domestic Product (GDP). Indonesia as a small open economy with imperfectly capital mobility, so temporary thesis of the Mundell-Fleming model is that monetary policy more effective than fiscal policy in improving of the GDP, that caused by its crowding out effect yielded from expansive\ fiscal policy. A variant of the Mundell Fleming model for the Indonesian economy is constructed and analysed using the Two Stage Least Square Methods (2sls). The result of two stage least square estimation indicating that the impact of monetary policy with money supply(M2) instrument is more effective in improving GDP than fiscal policy with government expenditure instrument . This result is proved with influences which are positive and significant among money supply (M2) variable and GDP from demand side. However, goverment expenditure variables give positive effect but not significant to the GDP. These finding support the Hypothesis of model Mundell-Fleming

Policy modeling on the GDP spillovers of carbon abatement policies between China and the United States

This paper simulates the GDP spillover effects between China and U.S. caused by the implementation of different climate protection policies. It is based on a combination of several climate protection models, which are the State-contingent Model and the Demeter Model, and the GDP Spillovers Model, known as the Mundell–Fleming model. From the simulation results, it is concluded that whether the United States implements policies on increasing carbon sink or not makes very little difference on the total output in the U.S. and the GDP spillovers toward China. However, the spillover impact of American carbon abatement policies on China experiences a varying trend that rises from negative to positive. These simulation results show that the climate protection policies of one country will have positive impact on the GDP spillovers of another country in the long term. This paper is focused on two conditions while simulating the GDP for both China and the U.S. Condition A within the simulations ignores the impact of GDP spillovers of foreign countries, while condition B takes the impact of GDP spillovers of foreign countries into consideration. Furthermore, this paper presents the simulated GDP of China and the U.S. under different scenarios and analyzes the level of GDP spillovers between the two countries. This paper concludes that carbon abatement policies in the U.S. have a larger and more noticeable GDP spillover effects to China.

Labor-Market Search, Financial Market Integration, and the Fiscal Multiplier

We used a two-country optimizing “new-open-economy macroeconomics” model to analyze the implications of financial market integration for the fiscal multiplier. The fiscal multiplier measures the accumulated effect of fiscal policy on output. Our model features a labor-market friction in the form of labor-market search. The conventional wisdom derived from the basic textbook version of the classic Mundell–Fleming model has been that financial market integration diminishes the fiscal multiplier. We show that labor-market search implies that financial market integration should increase rather than decrease the fiscal multiplier.

Theoretical Approaches to Monetary Policy Implementation in the Globalized Economy

The paper analyzes the main theoretical conceptions and forms of monetary policy implementation in the modern world. Mundell—Fleming model is viewed as the basic one, besides changes in underlying monetary policy conditions in the context of financial globalization are considered, including world inflation dynamics during the “Great Moderation” and factors behind it, the choice of exchange rate regime, the condition of the international monetary system, monetary policy transmission mechanism, theories on financial market development, and rising propensity to financial crises in national economies. Special attention is paid to those theoretical positions that can be used for the analysis of current Russian monetary policy.

Efficiency wages, financial market integration, and the fiscal multiplier

We used a “new-open economy macroeconomic” model featuring a labor-market friction in the form of efficiency wages to analyze the implications of financial market integration for the fiscal multiplier. The fiscal multiplier measures the accumulated effect of fiscal policy on output. Conventional wisdom based on the basic textbook version of the classic Mundell–Fleming model suggests that the fiscal multiplier should become smaller as financial markets become more integrated. We show that a labor-market friction in the form of efficiency wages implies that financial market integration should increase the fiscal multiplier.

When is money neutral under flexible exchange rates?

The paper studies the conditions for the neutrality of money under flexible exchange rates in an extended real-wage Mundell–Fleming model, with special emphasis on the specification of the behavior functions to correspond to their foundations in closed-economy macrotheory. It is shown that monetary expansion causes output first to decline, to eventually rise above its original level. However, if interest earnings on foreign securities dominate the trade balance in the expression for the exchange rate, monetary expansion leads to an appreciation of the exchange rate, while having an expansionary output effect. Money is neutral in the long run if either the wealth effect or foreign interest payments are abstracted from; if both are abstracted from, it is neutral also in the short run. Short and long-run neutrality results also if wealth consists only of foreign securities. The above responses hold both for net creditors and – with a minor qualification – debtors.

The Open Economy IS/LM Simulation Model: A User Guide

This is a user guide for the computer simulation of the short-run open economy IS/LM model (UVA-S-BP-0522.xls). The model is also known as the Mundell-Fleming model. We assume the user is a student who is studying the short-run open economy model in an intermediate level macroeconomics course. The simulation requires Microsoft Excel® version 2000 or newer to run.

Tunisia: Sources of Real Exchange Rate Fluctuations

Using structural VARs identified with long-run restrictions, this paper evaluates the importance of nominal shocks and real disturbances on the Tunisian Dinar during the nineties. The estimated macroeconomic behaviour in response to the shocks identified with a Clarida and Galiâ€type structural VAR for Tunisia is generally in line with theoretical priors stemming from the Mundell-Fleming model. The structural decomposition shows that relative real demand and supply shocks account for most of the variations in real exchange rate changes during the estimation period and indicates that real disturbances explain about 80% of the variance of the forecast error of the real exchange rate.

An Evaluation of the Contractionary Devaluation Hypothesis

Recent empirical and theoretical literature on the impact of real exchange rate devaluations on economic performance questions the traditional expansionary effect generated within standard Mundell-Fleming models. Contractionary devaluations may arise when firms face maturity or currency mismatches that, when faced with real exchange rate depreciations, lead to balance sheet effects that erode firm's wealth and lead to an output contraction. While some authors show that the standard Mundell-Fleming result may hold even in the presence of currency mismatches, others point out that if the balance-sheet effect is large enough devaluations can be contractionary. Using a large panel of 57 countries across the world and various newly constructed measures of dollarization, we test if the balance sheet effect hypothesis has been relevant during the past decades in explaining economic downturns. Additionally we explore the channels through which devaluations can be contractionary, in particular we explore if investment and consumption decisions are negatively affected by exchange rate devaluations under currency mismatches.

Monetary Policy in the Industrial World: Reflections on some Basic Issues*

This paper is a general assessment of monetary policy in major OECD countries during the 1990s. Within a simple policy framework that combines money growth, nominal income, and an open economy IS-LM type Mundell-Fleming model, the paper discusses the major strands in the conduct of monetary policy in developed industrial economies. It throws light on such problems as “rules versus discretion”, management of exchange rates, the effect of monetary changes on income and prices, and the rupture of monetary policy with other instruments of economic policy that also affect the economy.

International Transmission Effects of Monetary Policy Shocks: Can Asymmetric Price Setting Explain the Stylized Facts?

How does an unexpected domestic monetary expansion affect the foreign economy? Does it induce an increase or a decline in foreign production? In the traditional two-country Mundell-Fleming model, monetary policy has«beggar-thy-neighbor»effects. Yet, empirical evidence from VARs indicates that U.S. monetary policy has positive international transmission effects on both foreign (non-U.S. G-7) output and aggregate demand. In this paper, I will show that a two-country dynamic general equilibrium model with sticky prices can account for these «stylized facts» if we allow for international asymmetries in the price-setting behavior of firms. If U.S. firms set export prices in their own currency only (producer-currency pricing), whereas producers in the rest of the world price their exports to the U.S. in the local currency of the export market (local-currency pricing), a U.S. monetary expansion is found to increase output and aggregate demand abroad.

Analysis of Short-term Exchange Rate Movements in Korea: Application of an Extended Mundell–Fleming Model

Extending the Mundell–Fleming model and applying the Newey–West HAC method, this paper finds that the real USD/won exchange rate is negatively affected by real M2, the world interest rate, country risk, the expected inflation rate and the binary variable for the time period during the Asian financial crisis, and positively influenced by the stock market performance and the lagged dependent variable. The coefficient of real government deficit spending is positive but insignificant at the 10% level. Therefore, to maintain the stability of the won, the authorities need to pursue expansionary monetary and fiscal policies with caution, nurture a positive business and investment environment to reduce country risk, maintain a healthy stock market, and enhance the central bank's credibility to lower inflation expectations.

International transmission effects of monetary policy shocks: can asymmetric price setting explain the stylized facts?

How does an unexpected domestic monetary expansion affect the foreign economy? Does it induce an increase or a decline in foreign production? In the traditional two-country Mundell–Fleming model, monetary policy reveals ‘beggar-thy-neighbour’ effects. Yet, empirical evidence from VARs indicates that US monetary policy has positive international transmission effects on both foreign (non-US G-7) output and aggregate demand. In this paper, I show that a two-country dynamic general equilibrium model with sticky prices can account for these ‘stylized facts’ if we introduce international asymmetries in the price-setting behaviour of firms insofar as home (US) firms set export prices in their own currency only (producer-currency pricing), whereas producers in the rest of the world price their exports to the US in the local currency of the export market (local-currency pricing). Copyright © 2006 John Wiley & Sons, Ltd.

An Evaluation of the Contractionary Devaluation Hypothesis

Recent empirical and theoretical literature on the impact of real exchange rate devaluations on economic performance questions the traditional expansionary effect generated within standard Mundell-Fleming models. Contractionary devaluations may arise when firms face maturity or currency mismatches that, when faced with real exchange rate depreciations, lead to balance-sheet effects that erode firms’ wealth and lead to an output contraction. While some authors show that the standard Mundell-Fleming result may hold even in the presence of currency mismatches, others point out that, if the balance sheet effect is large enough, devaluations can be contractionary. Using a large panel of 57 countries across the world and various newly constructed measures of dollarization, we test whether the balance sheet effect hypothesis has been relevant during the past decades in explaining economic downturns. Additionally, we explore the channels through which devaluations can be contractionary; in particular, we explore whether investment and consumption decisions are negatively affected by exchange rate devaluations under currency mismatches.