04-12-2023

Errol D’Souza

The Mundell – Fleming Model

Macroeconomics of the Open Economy: Mundell Fleming
Errol D’Souza
Y = C + I +G + X −M

Add Net Factor Incomes from Abroad (NFI) and Trans-

fers from Abroad to the above identity:

Indian Institute of
Advanced Study
Rashtrapati Niwas
Shimla

Turin School
of Development

Email: errol@iimahd.ernet.in

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Errol D’Souza

Y + NFI + Transfers from Abroad = C + I + G + CA

Macroeconomics of the Open Economy: Mundell Fleming
Or, Y + NFI + Transfers from Abroad − C − G = I + CA
Y = C + I +G + X −M

Add Net Factor Incomes from Abroad (NFI) and Trans-

fers from Abroad to the above identity:

Y + NFI + Transfers from Abroad = C + I + G + X − M + NFI + Transfers from Abroad

However, the Current Account (CA) surplus is:

CA = X − M + NFI + Transfers from Abroad

Then,
Y + NFI + Transfers from Abroad = C + I + G + CA

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Y + NFI + Transfers from Abroad = C + I + G + CA

Current account surplus is the sum of the following –
Or, Y + NFI + Transfers from Abroad − C − G = I + CA
1) Balance of Merchandise Trade in goods

2) Net receipts from non factor incomes – services

S pvt + Sgovt or invisibles – such as travel, transport,
Then, insurance, and software exports
Spvt + Sgovt − CA = I
3)Net receipts from factor incomes from abroad –
net investment income earned by domestic
residents from abroad as well as compens-
ation to employees from abroad

4)Transfers – official transfers between govern-

ments and private transfers such as
remittances

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Spvt + Sgovt − CA = I
Current account surplus is the sum of the following –

1) Balance of Merchandise Trade in goods Spvt + Sgovt − NX = I

2) Net receipts from non factor incomes – services where, NX = X − M

X −M
or invisibles – such as travel, transport,
insurance, and software exports
Also, S pvt + Sgovt = S
3)Net receipts from factor incomes from abroad –
net investment income earned by domestic
Then, in an open economy national savings plus
residents from abroad as well as compens-
foreign savings – a deficit of net exports –
ation to employees from abroad
equals investment.
4)Transfers – official transfers between govern- Open Economy
ments and private transfers such as S − NX = I IS curve
remittances

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The net export function of an economy is given by IS-LM analysis focuses on short run.

   In the short run the price P in domestic currency

NX = NX  Y ,  EP * P  
 (−)  (+)  
An increase in income causes an increase in expend-
iture part of which is on foreign goods or imports.
Then, EP * = EP *
A depreciation of the real exchange rate makes exports
cheaper and imports more expensive and results
in an increase in net exports.
for the output which is to be exported and
the foreign price P* at which goods are imp-
orted into an economy are constant.
P P
Without loss of generality scale the domestic
and foreign price levels so that P = P* = 1 .

EP *
Then, =E
P

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Open Economy
   S − NX = I IS curve
Accordingly, NX = NX  (Y− ),  EP * P   = NX  (Y− ), (E+ ) 
(+)   

We know the determinants of national savings and

Investment:
As the price level is fixed the rate of change in prices
or inflation is zero and the reference interest S = S  i , Y , T , G  e 
 ( +) ( +) ( +) ( −) ( −) 
rate in this chapter is the real interest rate, r.
I = I  a , i ,  e 
 ( +) ( −) ( +) 
r = i − Inflation
Hence,
S  i , Y , T , G  e  − NX  Y , E  = I  a , i ,  e 
 ( + ) ( + ) ( + ) ( −) ( −)   ( −) ( + )   ( + ) ( −) ( + ) 

Let Y = Y0 , T = T0 , G = G0 ,  e =  0e , E = E0 , a = a0

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Panel A Panel B Panel A Panel B

i i i S (Y0 ;...) − NX (Y0 , E1 ) i
S (Y0 ;...) − NX (Y0 , E0 ) S (Y0 ;...) − NX (Y0 , E0 )

Q Q/
i1
i1
i0 i0
P i0 P/ P i0 P/

IS (E1 )
I IS (E0 ) I IS (E0 )

S, I Y0 Y S, I Y0 Y

Suppose now initial exchange rate is E0 . What happens Depreciation of the exchange rate results in NX↑. As a
when the exchange rate depreciates to E1 ? result, (S – NX)↓ to the dashed curve. The IS curve
shifts to the right.

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Table 11.1: Central Bank Balance Sheet

In what way is the LM curve different in an open ASSETS LIABILITIES
Advances (Credits) to Commercial Currency in circulation
economy? Private Sector
Recall the balance sheet of the central bank: Central Bank credit to government = Central Bank balances of domestic bank
Holdings of government debt (including deposits
Table 11.1: Central Bank Balance Sheet loans to government) less government
ASSETS LIABILITIES deposits
Advances (Credits) to Commercial Currency in circulation Credit to domestic banks
Private Sector Foreign Exchange Assets FECB Net Non Monetary Liabilities of Central
Bank
Central Bank credit to government = Central Bank balances of domestic bank
Holdings of government debt (including deposits On the liabilities side,
loans to government) less government
deposits
Credit to domestic banks
Reserve Money (M0 ) = Currency in Circulation
Foreign Exchange Assets FECB Net Non Monetary Liabilities of Central
Bank +
Central Bank balances of
domestic bank deposits

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Table 11.1: Central Bank Balance Sheet

ASSETS LIABILITIES Ignoring non-monetary liabilities of the central bank the
Advances (Credits) to Commercial Reserve Money M0 balance sheet of the central bank may be written
Private Sector
as -
Central Bank credit to government = Table11.2: Alternative Exposition of Central Bank Balance Sheet
Holdings of government debt (including
loans to government) less government Foreign Exchange Assets FECB Reserve Money M0
deposits
Domestic Credit Advanced DC
Credit to domestic banks
Foreign Exchange Assets FECB Net Non Monetary Liabilities of Central
Bank
Then,
On the assets side,
Domestic Credit (DC) = Central bank credit to government
M 0 = FE CB + DC
+ Central bank credit to domestic banks
+ Central bank credit to commercial private
sector

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Money supply is a multiple of the stock of high powered Money supply is a multiple of the stock of high powered
or reserve money . When m is the money multi- or reserve money . When m is the money multi-
plier, plier,

M s = mM 0 = mFECB + DC M s = mM 0 = mFECB + DC

Money demand is unchanged in an open economy and

is given by M d P = f (Y , i ) .

Money market equilibrium is where money supply

equals money demand -
M s = mFECB + DC = f (Y , i ) = M d

This is the equation for the open economy LM curve.

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Errol D’Souza Errol D’Souza

Financial Market: LM Curve Capital Mobility: How open is the capital account of
MD an economy
= f (Y , i ), f Y  O, f i  0
P

M = m(FECB + DC)
S What are the determinants of net capital flows on the
capital account of the balance of payments?
MD =MS =M

i
Net capital inflows (NKI) into an economy occur when
the domestic interest rate there is higher than
LM Curve the interest rate abroad inclusive of the percent
by which the exchange rate is expected to
depreciate, or,
Ee − E
i  i*+
Y E

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Revised definition in order to ease notation: Capital controls affect the capital flows into or out
of a country.
i* : Exogenously given foreign interest rate that
includes the expected depreciation of Direct or administrative measures
Types of
the domestic currency
capital
controls
Then, Indirect or market based measures

Net Capital Inflow = NKI (i − i *) Direct controls place restrictions on the movement of
(+ )
capital and the associated payments and trans-
fers of funds through outright prohibitions,
explicit quantitative limits on such capital flows,
or, the requirements that they be subject to
approval procedures.

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Indirect or market based controls include –

Chile introduced a mixture of direct and indirect
(a) Explicit taxation of external financial trans- controls in 1991 –
actions. For example countries may mandate
that taxes are to be paid only on short term Indirect control: percentage of foreign borrowing
inflows with the intention of changing the be left in an unremunerated reserve
composition of capital inflows towards those requirement or non-interest bearing
that are more enduring. deposit at central bank for a year
(b) Indirect taxation of cross-border flows such as
requiring residents to deposit at zero interest Direct control: all FDI to stay in the country for
rates a proportion of the flows at the central at least a year
bank, and
(c) A dual or multiple exchange rate system where
different exchange rates apply to different types
of transactions.

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Capital Immobility –
Regimes of capital controls – When there is complete restriction on the
mobility of capital across borders
Perfect capital immobility
A change in the domestic interest rate vis-à-vis
Perfect capital mobility the foreign interest rate, has no impact
on foreign capital flows
Imperfect capital mobility
i

NKI
Capital Immobility

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Imperfect capital mobility –

Perfect capital mobility – International interest rate differentials result in
There are no restrictions on capital flows and finite flows into or out of a country.
capital migrates wherever the return is This is due to (a) capital controls, (b) a limited
higher. supply of arbitrage funds, or, (c) risk aver-
As domestic and foreign assets are perfect sub- sion to putting more than a certain amount
stitutes large flows of capital of funds into the destination country.
i occur for even a small deviat-
tion of i from i* i
Our focus
will be on
i* this type
of capital
account
transactions
NKI
Perfect Capital Mobility NKI
Imperfect Capital
Mobility

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