Nta UGC-NET dec-2018

Online batch ,Lecture-28

Macro eco Topic- 13

MUNDELL-FLEMING MODEL
&
OTHER TOPICS
UGC-NET PAPER-2 (ECO)
Mundell-Fleming Model:
 Meaning of the Mundell-Fleming Model:

this model developed by Robert Mundell, now a professor at Columbia

University and the Late Marcus Fleming in 1960’s

The basic Mundell-Fleming model — like the IS-LM model — is based on the
assumption of fixed price level and shows the interaction between the goods
market and the money market.

The model explains the causes of short-run fluctuations in aggregate income in

an open economy.

The Mundell-Fleming model is based on a very restrictive assumption. It

considers a small open economy with perfect capital mobility.

This means that the economy can borrow or lend freely from the international
capital markets at the prevailing rate of interest since its domestic rate of
interest is determined by the world rate of interest.
This means that macroeconomic adjustment occurs only through exchange rate
changes.

The central bank permits the exchange rate to move up or down in response to
changing economic conditions.

The basic assumption of this model is that the domestic rate of interest (r) is
equal to the world rate of interest (r*) in a small open economy with perfect
capital mobility.

No doubt any change within the domestic economy may alter the domestic
rate of interest, but the rate of interest cannot stay out of line with the world
rate of interest for long.
The difference between the two, if any, is removed quickly through inflows and
outflows of financial capital.

A small country is one which cannot alter the world rate of interest through its
own borrowing and lending activities.

In contrast, a large economy is one which has market (bargaining) power so

that it can exert influence over the world rate of interest.

For such a country, either international capital mobility is far from perfect, or
the country is so large that it can influence on world capital markets.

The main prediction from the Mundell-Fleming model is that the behaviour of
an economy depends crucially on the exchange rate system it adopts, i.e.,
whether it operates a floating exchange rate system or a fixed exchange rate
system.

We start with adjustment under a floating exchange rate system, in which case
there is no central bank intervention in the foreign exchange market.
 Assumption

(1) A small open economy

(2) Tax rates are the same everywhere,

(3) Foreign investors do not face political risk .

Under these conditions and with perfect mobility of capital investors or foreign
asset holders would try to invest in the asset in any country that yields the
highest return.

This would force rates of return on assets to become equal everywhere in the
international capital markets because no one would invest at a lower return.
It may however be noted that perfect equalization of returns in different countries is
crucially dependent on the twin assumptions of perfect mobility of capital and fixed
foreign or world interest rate for an economy.

In fact, Mundell-Fleming model assumes a small open economy which is incapable

of influencing world interest rate.

The assumption of a small open economy with perfect capital mobility plays an
important role in Mundell-Fleming model.
 Mathematically, we can state this assumption as:

r = rf

where r stands for domestic interest rate in the economy and rf is

the world rate of interest.

It is the perfect mobility of capital that makes domestic interest

rate (r) equal to the world interest rate.

On the other hand, if some event or policy causes domestic

interest to exceed world interest rate,

then the capital inflows would bring down the domestic interest
rate to the level of world interest rate.
Hence the equation r = rf represents that international flow of
capital quickly brings the domestic interest rate equal to the world
interest rate.

The Mundell-Fleming model, with domestic interest rate

determined by the world interest rate, focuses on the role of
exchange rate in the determination of national income in the
short run.
The Mundell-Fleming model of a small open economy with perfect capital
mobility can be described by the following equations for IS and IM curves

IS equation:

Y = C (Y- T) + I(rf) + G + NX(R)

LM equation:

M/P = L(rf, Y)

The IS equation describes the goods marks equilibrium and the second LM
equation describes money market equilibrium.

G and T are the variables determined by fiscal policy, M is the monetary policy
.

The price P and (rf) world interest rate.

Expansionary Monetary Policy under Fixed Exchange
Rate and Perfect Capital Mobility:

in panel (a) we have drawn the IS and LM

curves as well as the horizontal straight line BP.

The horizontal line BP= 0 at domestic

interest rate i equal to foreign interest rate
if (i = if) shoes that the country has neither
deficit or surplus in its balance of payments,
that is, its balance of payments is in
equilibrium.

Government adopts a policy of monetary

expansion.

Let the economy in panel (a) is initially at

point E where the given IS-LM curves
intersect at E which determines domestic rate
of interest i which is equal to foreign rate of
interest if.
With monetary expansion, LM curve shifts
to the right and as a result the economy
moves to the new equilibrium position E’

where domestic rate of interest has fallen

to i1 .

At the new position E’ economy will have a

large deficit in balance of payments which
will exert a pressure on the exchange rate
of domestic currency to depreciate.

Determination of foreign exchange rate is

shown in panel (b) where initially demand
curve DD and supply curve SS of US
dollars determine exchange rate equal to
OR (i.e. number of rupees per US dollar).
When as a result of expansion in money supply, LM1 curve shifts to the right to
the new position LM and consequently domestic rate of interest falls to i1 there
will be large capital outflows.
These capital outflows will reduce the supply of
US dollars in foreign exchange market and as a
result supply curve of US dollars shifts to the
left to S’S’

resulting in the new exchange rate R’

(that is, more rupees per US dollar).

This means Indian rupee will depreciate.

To maintain the exchange rate, the
Central Bank of the country will
intervene; it will sell foreign currency
reserves in the foreign exchange market.

The supply of domestic money supply in the

economy will therefore decrease.
 As a result of this reduction in domestic
money supply, LM curve will shift back to
the left

This process of contraction in money

supply and consequent shifting back of LM
curve to the left will continue until the
initial equilibrium at E is reached again.

As a matter of fact, with perfect capital

mobility, the economy is not likely to
reach at the new equilibrium joint E’. This
is because the response of capital flows is
so large and quick that the Central Bank
will be forced to reverse quickly the initial
expansion in money supply before the new
equilibrium at E’ is reached.
Mundell-Fleming Model: Role of Expansionary Fiscal
Policy under Fixed Exchange Rate System:

Suppose adopting expansionary fiscal policy

Government increases its expenditure with
money supply remaining unchanged.

It will be seen from panel (a) that increase

in government expenditure causes shift in
the IS curve to the right to the new position
IS’.

As will be seen from panel (a) this raises

both the interest rate and level of national
income (output).

The higher domestic rate of interest as

compared to the world interest rate (i f) will
cause capital inflows into the economy.
 These capital inflows will bring about
appreciation in exchange rate of national
currency.
It will be observed from panel (b) that as a
result of capital inflows, supply curve of
foreign exchange (i.e. US dollars) shifts to the
right from SS to S’S’.

The new supply curve S’S’ of foreign

exchange rate intersects the demand curve
for foreign exchange at point Q’ and
determines the lower new foreign exchange
rate R’ (rupees per US dollar).
money supply is increased so much that
LM curve shifts to the new position LM’
and domestic rate of interest falls back to This implies that there is appreciation of
the original level so that it is again equal rupee. To maintain the exchange rate at R
to the world interest rate (I = if). the Central Bank will have to expand money
supply which will cause a shift in LM curve
to the right and increase national income
Fiscal expansion leads to increase in further.
national income by Y1 Y3, equal to the
Keynesian multiplier effect.
Balance of Payment Account
 Balance of Payment Account

A Balance of Payment Account is a systematic record of all economic

transactions between residents of a country and the rest of the world
carried out in a specific period of time.

Components of BOP Accounts:

A. The B. The C. The D. The Official

Current Capital Unilateral Reserve
Account: Account: transaction Account:
In addition to imports and exports, it also takes into consideration the
amount receivable or payable as regards to:

(1) Cargo freight charges,

(2) Port charges,

(3) Expenditure on account of foreign visits for tours

, education, medical treatment, business etc.,
(4) Purchase of fuel for ships and provision for crews,

(5) Maintenance of embassies abroad,

(6) Remittance of foreign nationals, foreign loans and the repayment of

interest thereon,

(7) Remittance of profit of foreign enterprises and development grants, etc.

 A. The Current Account:

Balance of payment of a current account is a statement of actual

receipts and payments in the short period. It includes imports and
exports of both material goods and services. Items of current account
are actually transacted.

Components or Items of Current Account:

Those components are broadly classified as visible items and invisible

items.

1. Exports and Imports of Visible Items or Goods:

All visible and material goods which are exported and imported
constitute items of current account. The record of these goods is
available with the ports of the country.
2. Invisible Items or Non-material Goods or Services:

The non-material goods or services inflow and outflow within the

country from abroad, cannot be accounted in the records and can also
not be seen and touched.

Following is the list of few items pertaining to the category.

(i) Transportation and Travelling Services:

(ii) Services of the Experts:

(iii) Investment Income and Expenses:

Rent, interest, profit and dividend are also invisible items of balance of
payments. Receiving income from abroad is termed as receipt in foreign
currency.
(iv) Donation and Gifts:

(v) Services Rendered by Commercial Undertakings:

The allied trade and commerce firms such as shipping companies, banks,
and insurance companies etc.

(vi) Government Transactions:

Generally, the Government of every country provides the services of
embassies, offices of high commissioners and other missions abroad.

(vii) Miscellaneous:

The miscellaneous or invisible items such as commission,

advertisement, royalties, patent fees, rent, membership fees etc., are
provided to abroad and received payments from abroad.
 2. Capital Account:

All types of short-term and long-term international capital transfers,

movement of gold and billion metals, receipts and payments of private
and government accounts, institutional and private loans, interest,
profit, grants etc are the part of capital account.

As capital account is concerned with financial transfers, so they have no

direct effect on income, output and employment of the country.
 Component of Capital Account:

(i) Gold Movement:

Central bank of every country buys and sells gold from home and to
abroad. It means that exports and imports of the gold by the central
bank which makes the payments and receipts of amount of gold.

(ii) Reserve, Monetary Gold and SDR:

Governments’ foreign currency assets, gold reserves of Central bank,
SDR of the IMF and other similar capital transactions,

(iii) Movement in Banking Capital:

Inflow of banking capital besides central bank is reflected under “credit

items” and outflow of banking capital besides central bank is reflected
under “debit items”.
(iv) Private Foreign Loan Flow:

(v) Official Capital Transactions:

Public sectors of the country receive foreign loans from International

Monetary Fund.
 3. Unilateral Transfer Account:

This account is somewhat like the capital account, except that it involves
capital movements and gifts for which there are no return commitments
or claims.

Thus, a personal remittance to a resident of a foreign country involves

no commitment for repayment and is classified as a unilateral transfer.

These unilateral transfers may be on private account or governmental

accounts in the form of grants.
 4. Official Reserve Transaction Account:

Official reserve asset account.

This consists of changes in international reserve assets – those used for

setting accounts between government central banks.

On account of deficit or surplus emerging out in capital account, current

account and unilateral transfers with other countries, the inter-
governmental settlements needed to be done regularly.

To finance deficit and surplus emerging out on account of Balance of

payment position, the particular country has to use the international
reserve assets.

The convertible currencies like US Dollar, gold, monetary gold, SDR

allocations by the IMF and foreign currency assets are few examples of
international reserve assets.
If the overall balance of payments is surplus, the surplus, the surplus
amount adds to the official reserve account.

If the overall balance of payments is deficit and if accommodation

capital is not available, the official reserve account balance is reduced by
the amount of deficit.
The overall balance of payments is calculated as under:
 (i) Tarapore Committee:
The Tarapore Committee, set-up by the Reserve Bank of India
(RBI) in 1997, under the guidance of Mr. Tarapore has
defined capital account convertibility as the freedom to
convert local financial assets into foreign financial assets and
vice-versa at market determined exchange rates.

(ii) Rangarajan Committee:

The Rangarajan Committee, set up for the purpose of Balance of
Payments, has recommended the introduction of market-determined
exchange rate.
 Golden Rule of Capital Accumulation

Edmund Phelps while describing the golden age growth lays down
the golden rule of accumulation.

As per Golden Rule of Accumulation, per capital consumption is

optimised in a golden age when the thrift rate(saving) equal to profit
rate.

Per capita consumption

If the thrift rate is lower than the profit
rate, the per capital consumption is
profit

lower than the achievable maximum.

Alternatively, if the thrift rate is higher

than the profit rate, per capita
saving consumption will turn down.
Therefore, it is a specific objective rate
of thrift that optimizes per capita
consumption in a golden age.

This is known as the golden rule saving

rate or maximum thrift rate.

It is only saving rate that maximise per

capita consumption in golden age.

Maximum PCC called golden rule of

accumulation.
 Trickle-down effect

The trickle-down effect is a model of product adoption in marketing

that affects many consumer goods and services.

It states that fashion flows vertically from the upper classes to the
lower classes within society, each social class influenced by a higher
social class.

It means economic benefit provided to upper income level earner

will help society as a whole.

In this approach their extra wealth will be spent into the economy
providing wealth for lower income earner and creating jobs.
 Trickle-up effect

This theory was founded by [Link].

The trickle up effect states that benefits to the wealthy will be realized
due to an increase in sales relative to the amount of benefits that are
given to the poor.

The trickle up effect argues itself as more effective than the trickle down
effect because people who have less tend to buy more.

This being so, proponents of the trickle up effect believe that if the
lower and lower-middle classes are given benefits, such as tax breaks or
subsidies,

Conclusion- it describe the flow of wealth from the poor to rich. It is

opposite of trickle down.
 Some imp points.
The committee for abolition of BIFR -1987 – [Link]
committee.

Abolition of Competition commission of india (CCI)- Narshimahm

committee.

Pink sheat is related with – world bank committees price data.

Snake in tunnel releted with- foreign exchange.

PPP theory developed by- Gastav Casal.

Dutch disease is related to- natural resourses.

Potential output called- the natural gross domestic product.

The concept of effective revenue deficit fist time used in the budget
of 2011-12.

The theory Glut given by- Ricardo.

Multiple effect of balance budget given by- [Link]

Nta UGC-NET dec-2018
Online batch ,Lecture-29

Growth and Development, topic 1

Measuring development
&
Measuring inequality
UGC-NET PAPER-2 (ECO)