MUNDELL FLEMING MODEL

Mundell Fleming Model



Mundell Fleming Model

Introduction

In this paper we will be using Mundell-Fleming model and will be analyzing the movement of exchange rates of US/AUD. For over thirty years, the Mundell-Fleming model has served not only as a template for research in international macroeconomics, but also as an important pedagogical tool. The underlying pedagogical value of the model is that it can be combined with other models to explain how different exogenous factors impact the balance of payments and the exchange rate. The purpose of this paper, in turn, is to elucidate the pedagogical value of the Mundell-Fleming model by presenting a traditional market model consisting of their model and a Keynesian-Hicksian IS/LM and aggregate supply and demand curve model that can be used to evaluate the impacts macroeconomic policies and events have on exchange rates (Fleming, 1962: 369).

Discussion Analysis

The models of exchange-rate determination based on the monetary approach to the balance of payments, on the other hand, assume that exchange rates are determined by the long-run average of money stock differentials and the arbitrage-free purchasing power parity condition (Dornbush, 1976: 231). In explaining the determinants of exchange rates, the monetarist model maintains that inflationary expectations based on money supply differentials dominate all other factors. In contrast to the asset-market approach, monetarists posit that efficient currency market conditions exist such that exogenous shocks that alter inflation expectations and relative prices lead to a relatively quick change in the level of exchange rates. Empirical studies, though, have questioned the role of relative prices in determining exchange rates. In a 1986 study, Mussa found that price levels had little impact in explaining the variability of real and nominal exchange rates. In a more recent study, Engel (1999) found large price disparities between arbitraged tradable goods (Dornbush, 1976: 161).

The open-economy macroeconomics models are the most recent approach to explaining international macroeconomics and exchange-rate determination. Models and research related to this approach are a product of the accumulation of empirical evidence showing the existence of sticky (or preset) prices and barriers between trading countries. The open-economy macroeconomics models synthesize Keynesian normal rigidity conditions and imperfect competition to explain these empirical regularities (Engel, 1993: 35).

Finally, the classic Mundell-Fleming model explains the equilibrium exchange rate in terms of a traditional macroeconomic model and the foreign currency supply and demand market model. Their model and related works represent an extension of the seminal work of James Meade (1951). Meade's treatise on the balance of payments combined Keynesian economic conditions with monetary factors to explain the balance of payments, the economic impacts of devaluations, and the factors governing the flexible exchange rate system. As Frenkel and Razin (1987) point out, Mundell's model extended Mead's work by providing the explanation of how international capital flows and monetary changes worked to restore internal and external equilibriums (Frenkel & Assaf , 1987: 567). Related works by Mundell and Fleming subsequently addressed how fixed and flexible exchange-rate systems adjusted to exogenous shocks, the importance of fiscal policy for ...