Fundamentals of the Fleming-

Mundell Model
Macroeconomic Policy in an Open
Economy
 Background
• 1948-1973: System of fixed exchange rates, major
currencies pegged to the US Dollar.
• In case of disequilibrium, countries devalued or re-
valued.
• 1950’s and 1960’s aims of macroeconomic policy:
Achieving full employment along with a stable price level
(Internal Balance)
• Implications for balance of payments because of the
increase in national income.
• Increase in employment and Y leads to more imports
and the deterioration of the current account.
• Fixed exchange rates implied selling reserves to
achieve “External Balance”, or equilibrium in the
BoP.
• Expenditure changing policies= changes in fiscal
and monetary policy aimed to influence the level
of aggregate demand in the economy
• Expenditure switching policies= policies that
attempt to change the composition of spending
between domestic and foreign goods. Example:
devaluation/ revaluation of the exchange rate.
• 1950’s and 1960’s literature focused on
achieving “internal” and “external” balance
simultaneously
• Trevor Swann: Swann Diagram
• Y- axis: exchange rate in £/$: rise implies
depreciation of domestic currency and
improved international competitiveness.
• X- axis: amount of real domestic
absorption: C+I+G
Trevor Swan (1918–1989)
Figure 4.1 The Swan diagram
• IB: Combinations of real exchange rate
and domestic absorption for which the
economy is in internal balance: full
employment and stable prices.
• Downward sloping: Appreciation reduces
exports and increases imports
• To maintain full employment, domestic
expenditure must rise
• EB: Combinations of real exchange rate
and real domestic absorption for which the
economy is in external balance:
equilibrium in the current account.
• Upward sloping: depreciation of exchange
rate will increase exports and reduce
imports
• Domestic expenditure has to increase to
offset the decrease in imports
• Right of the EB schedule: Domestic
expenditure is greater than required for the
CA equilibrium. Consequence: deficit
• Left of the EB schedule: Domestic
expenditure is lower than required for the
CA equilibrium. Consequence: surplus
• Swann Diagram: 4 zones
• A: Internal and external equilibrium
• Departing from point B: inflation and deficit
• Fixed exchange rate
• Reduction of CA deficit by cutting back on
real domestic expenditure
• Result: point C
• Economy may be pushed into recession
with unemployment
• Alternative: tackling deficit by devaluing
exchange rate
• Point D
• Devaluation reduces current account deficit but
adds inflationary pressures
• D: further away from internal balance IB
• To move from B to A, authorities need to deflate
(reduce absorption) and devalue.
• Swann Diagram: simplistic and no role for capital
movements
• No distinction between monetary and fiscal
policies
 The Fleming- Mundell model
• James Fleming (1962)
• Robert Mundell (1962-3)
• Based on the IS-LM model
• G and X are autonomous with respect to
interest rate and level of national income.
 　 John Marcus Fleming (1911 – 1976)
Robert Mundell 1932-
Equation 4.1
Equation 4.2
Equation 4.3
Equation 4.4
Equation 4.5
Figure 4.2 Derivation of the IS schedule
• 1: Leakages vs. Income
Upward sloping: increases in income leads
to increases in savings and imports
slope=1/(s+m)
• 2: Leakages transferred from 1. 45 degree
line: converts leakages into equivalent
amount of injections
• 3. Injections with corresponding levels of
interest rates (at a given price level)
• Injections schedule: downward sloping
because investments are inversely related
to interest rate. G and X are independent
from r.
• Y1 generates L1 which are equal to IN1 at
an r1
• 4. IS curve from an open economy
• at r1 and Y1 leakages are equal to
injections
• Curve is downward sloping: higher levels
of income generate higher levels of
leakages
• Interest rate has to fall to stimulate
investment and maintain balance between
injections and leakages
 Derivation of the LM curve for an
open economy
• LM: Various combinations of interest rate and
levels of income for which the money market is
in equilibrium.
• Assumptions:
• Money is demanded for 2 reasons:
• 1. Transactions purposes
• 2. Speculation purposes
• The higher the level of income, the higher the
demand for money for transactions purposes
Equation 4.6
• Mt= Transactions demand for money.
• Speculative balances: any money held in excess
of the money needed for transactions
• If r rises, opportunity cost of holding money
rises: Inverse relation between Msp and r
• d Msp/dr<0
• In equilibrium, money supply equals money
demand
Figure 4.3 Derivation of the LM schedule
• 1: Transactions demand for money as
positive function of the income
• 2: Transactions balanced distribution of
money supply between transactions and
speculation balances
• 3: Speculative demand for money vs. r.
(inversely related)
• 4: LM curve: at r and Y, Msp+Mt=MS
• LM is upward sloping: high income levels
require large transactions balances
• If money supply is given, they can only be
drawn out of speculative balances by a
relatively high interest rate
 Derivation of the BP schedule for
an open economy
• Different combinations of r and Y are
compatible with BP equilibrium
• BP=CA +capital account
• Exports: Independent from Y
• Imports: Positively related to income
• Ma= autonomous M
• m= marginal propensity to import
• M=Ma+mY
• If there’s CA deficit, there needs to be a capital
account surplus to have equilibrium in BP.
• The higher the level of income, the smaller the
current account surplus or the larger the deficit,
due to the marginal propensity to import.
• Net capital flow K is a positive function of r.
• Assuming r* is fixed, the higher r, the greater the
capital inflow or the smaller the capital outflow.
Equation 4.10
• Equilibrium in BP
• X-M+K=0
• Positive K: net inflow of funds
• Negative K: net outflow of funds
• Derivation of BP schedule:
• 1. CA vs. Y : downward slope: increases in income lead
to a deterioration of the current account.
• 2. CA surpluses or deficits. 45 degree line converts the
CA position into an equal capital flow of opposite sign.
• 3. r required for a given capital flow. Downward sloping:
high r encourages capital inflow and vice versa
• 4. BP curve: Y vs. r at which BP is in equilibrium.
Upward sloping: higher levels of income cause a
deterioration of the current account: need for lower
capital outflow or higher capital inflow, requiring a higher
interest rate
Figure 4.4 Derivation of the BP schedule
• Left of the BP: surplus: for current levels of capital flows,
CA is better than required for equilibrium, as Y is lower.
• Right of BP: deficit: Y higher than the one compatible
with equilibrium
• Slope of BP: determined by the degree of capital mobility
internationally: the higher the mobility, the flatter the BP.
• Reason: the higher the degree of capital mobility, the
smaller the rise in r required to attract foreign capital to
ensure BP equilibrium,
• Given an initial increase in Y that would cause a CA
deterioration
• Horizontal BP: Perfect capital mobility
• Vertical BP: no capital mobility
• Upward sloping BP: capital is imperfectly
mobile.
Figure 4.5 Equilibrium of the model
Equilibrium of the Fleming- Mundell
model
• BP is steeper than LM, but it does not
need to be this way (changes in slopes
imply different policy prescriptions
• All lines meet at r1 and Y1
• Y1: less than full employment level
• Economy is not in internal balance
• There is external balance: BP in
equilibrium because IS and LM intersect at
a point on the BP line.
• IS-LM do not intersect at full employment
Yf because Yf planned leakages (S+M)
exceed planned injections (C+I+G), which
would build up stocks of unsold goods
leading producers to reduce output.
• Only at Y1 do leakages equal planned
injections.
Figure 4.6 Surplus (a) and deficit (b) in the balance
of payments
• a) IS and LM intersect left of BP: surplus
reasons: either level of income is too low
and/ or rate of interest is too high to meet
overall equilibrium.
• b) Balance of payments deficit: IS and LM
intersect to the right of BP- Income level
Y2 is too high or interest level r2 too low to
meet overall equilibrium.