Limitations of the Mundell-Fleming Model

Limitations of the Mundell-Fleming Model

In an increasingly globalized marketplace, understanding the forces at play has become more challenging that ever before. Fortunately, economists have some useful tools at their disposal to help them make sense of things, with one of these being the Mundell-Fleming model. All of the models share in common the fact that they are better suited for some purposes than others, and the Mundell-Fleming model is no exception. For example, on the one hand, the Mundell-Fleming model provides analysts which a framework in which the impact of the behavior of international markets on national economies can be investigated; on the other hand, though, as with any economic model, the value of the results of this analysis will depend on the identification of the critical issues that are involved in order to explain the origins of current account imbalances and the consequences of changes in fiscal and monetary policies (Bosworth, 1993). To help identify some of the limitations of the Mundell-Fleming model, this paper provides a critical analysis of the peer-reviewed and scholarly literature, followed by a summary of the research and salient findings in the conclusion.

Review and Discussion

In their essay, "The Mundell-Fleming Model Revisted," Fan and Fan (2002) report that following his receipt of the 1999 Nobel Prize for Economics to Robert Mundell, one of his major contributions, the Mundell-Fleming model, became the focus of an increasing amount of attention: "Because of the expansion in international trade and the globalization of international finance, many developing and transitional economies in the world are facing the problem of choosing an appropriate exchange rate regime" (Fan & Fan, 2002, p. 42). According to Macdonald (1993), "The basic focal point of the Mundell-Fleming model is a small open economy with unemployed resources, a perfectly elastic aggregate supply curve, static exchange rate expectations and perfect capital mobility. Given such assumptions it can be demonstrated that with flexible exchange rates monetary policy is extremely powerful in altering real output and fiscal policy is completely impotent" (p. 41). Considering the improvement in international capital mobility, an increasing number of small countries have elected to use a pegged (fixed) exchange rate system; according to Mundell and Fleming, though, when a small country attempts to maintain a fixed exchange rate in a world of perfect capital mobility, money stock becomes endogenous. In this regard, Fan and Fan note that, "This result renders the monetary policy completely ineffective as a stabilization policy instrument" (p. 43).

According to Bosworth (1993), "The trade balance, saving, and investment are all interrelated parts of a system in which the relative importance of domestic and foreign factors can only be evaluated through an empirical model that accounts for the changes in saving, investment, and trade flows" (p. 36). In recent years, a number of empirical models have emerged; however, economists remain divided concerning which model structure is most appropriate for these analyses. In this regard, Bosworth reports that, "Nearly all of these models begin from a common theoretical point of departure that countries trade with one another and are linked through international financial markets" (p. 37).

The Mundell-Fleming model is a direct extension of the IS-LM analysis advanced by J.R. Hicks; this original model was intended to analyze the aggregate demand in a closed economy (Bosworth, 1993). This author adds that, "The two major additions are the introduction of the real exchange rate as a determinant of net exports and the use of the accounting requirement for balance of payments equilibrium as the framework for summarizing the forces that determine the exchange rate" (Bosworth, 1993, p. 38). The Mundell-Fleming model is most graphically illustrated under the assumption of constant prices with the following three equations as shown in Figure 1 below.

E (Y, r) + NX (q, Y, Y*)

PL (Y, r)

NX - B (B, r, r *, q, q + ?) = 0.

Figure 1. The Mundell-Fleming model.

Note: All foreign values are indicated with an asterisk and are assumed to be exogenous; the sign of the partial derivative is denoted above each symbol.

Source: Bosworth, 1993, p. 37.

Notwithstanding it's the Mundell-Fleming Model's usefulness for certain applications are described above, it does have its constraints. According to Eichengreen and Frieden (2001), "The fixed vs. floating debate for Europe has largely been carried out (sometimes implicitly) in the context of the Mundell-Fleming model, so this model is the appropriate venue to consider the implications of local currency pricing. However, in this model, behavior is not based explicitly on optimization" (p. 92). These authors cite four fundamental limitations with the Mundell-Fleming Model:

Companies may hedge their exchange rate gains and losses in various ways; e.g., they might use derivatives to protect themselves from foreign exchange fluctuation.

In the alternative, some of their costs may be borne in the currency of the location where the good is sold; e.g., the firm might do some production or assembly in the buyer's country and at a minimum, marketing and distribution costs may be denominated in the buyer's currency in which case a change in the exchange rate changes costs and revenues in the same direction so that the impact on profits is diminished.