Limitations of the Mundell-Fleming Model Explained

Introduction

In an increasingly globalized marketplace, understanding the forces at play has become more challenging than 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 economic models share in common the fact that they are better suited for some purposes than others, and the Mundell-Fleming model is no exception. On the one hand, the Mundell-Fleming model provides analysts with a framework in which the impact of international markets on national economies can be investigated. On the other hand, as with any economic model, the value of this analysis will depend on the identification of the critical issues involved in order to explain the origins of current account imbalances and the consequences of changes in fiscal and monetary policies (Bosworth, 1993). This paper provides a critical analysis of the peer-reviewed and scholarly literature on the model's limitations, followed by a summary of the research and salient findings in the conclusion.

In their essay "The Mundell-Fleming Model Revisited," Fan and Fan (2002) report that following the award of the 1999 Nobel Prize in Economics to Robert Mundell, one of his major contributions — the Mundell-Fleming model — became the focus of increasing 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).

The Mundell-Fleming model is a direct extension of the IS-LM analysis advanced by J. R. Hicks; that original model was intended to analyze aggregate demand in a closed economy (Bosworth, 1993). As Bosworth explains, "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" (1993, p. 38).

Background and Theoretical Foundations

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. Bosworth notes 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).

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, however, when a small country attempts to maintain a fixed exchange rate in a world of perfect capital mobility, money stock becomes endogenous. Fan and Fan note that "this result renders the monetary policy completely ineffective as a stabilization policy instrument" (p. 43).

The Mundell-Fleming model is most graphically illustrated under the assumption of constant prices with the following three equations:

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

Core Assumptions and Policy Implications

PL (Y, r)

NX − B (B, r, r*, q, q + ?) = 0

Figure 1. The Mundell-Fleming model. 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.)

Conclusion

The research showed that the basic focus of the Mundell-Fleming model is a small open economy characterized by unemployed resources, a perfectly elastic aggregate supply curve, static exchange rate expectations, and perfect capital mobility. If these assumptions hold true, the model can provide useful insights concerning the inefficacy of fiscal policies for these purposes. However, many experts have cited numerous constraints with the model since its introduction. Given the dynamic nature of the international marketplace today — particularly as it regards small emerging nations with fragile economies — the Mundell-Fleming model can still provide analysts with valuable information, provided that the variables used are selected carefully and the results are interpreted with the various limitations described above kept firmly in mind.