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Fixed prices: The Mundell –

Flaming Model
Chapter 6
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Mundell – Flaming Model
6.1 Setting
6.1.1 Domestic economy
Assumption 6.1. The aggregate supply curve is flat.

6.1.2 Balance of payments

- Current account
Assumption 6.2. PPP does not hold, even in the long run. Instead, the
size of the current account surplus depends positively on the (real)
exchange rate and negatively on (real) income.
B = B( y, Q) = B( y, S) By < 0 Bs > 03
- Capital account
Assumption 6.3. Exchange rate expectations are static.
Assumption 6.4. Capital mobility is less than perfect.
K = K(r − r*) = K(r) K′ > 0
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- Balance of payment locus
Adding 2 equations from previous section, we will have:

B( y, S) + K(r) = 0

 F( y, S, r) = 0 Fy < 0 , Fs > 0, Fr > 0

Notice that even in a pure float, the economy does not have to settle on
the TT line, because we do not require the current account to balance –
neither in short- nor long-run equilibrium. We only insist that any current
account deficit (surplus) be offset by a capital account surplus (deficit) of
the same size.
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6.3 Monetary expansion with a floating exchange rate
Proposition 6.1. In the M–F model of a floating exchange rate, a money
supply increase causes:
• a depreciation in the exchange rate
• an increase in income
• a fall in the interest rate, provided capital is not completely mobile
• an improvement in the current account of the balance of payments.

6.4 Fiscal expansion with a floating exchange rate

Proposition 6.2. In the M–F model of a floating exchange rate, fiscal
expansion causes:
• an appreciation in the exchange rate
• an increase in income, provided capital is not completely mobile
• a rise in the interest rate, provided capital is not completely mobile
• a deterioration in the current account of the balance of payments.
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Mundell – Flaming Model
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6.5 Monetary expansion with a fixed exchange rate

Proposition 6.3. In the M–F model of a fixed exchange rate,

a money supply increase causes:
• in the short term, and provided capital is not completely
mobile, the interest rate to fall, income to increase and the
balance of payments to deteriorate on both current and
capital account
• in the long term, a fall in the foreign currency reserves,
but no change in income, the interest rate or the balance
of payments.
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Mundell – Flaming Model
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6.6 Fiscal expansion with a fixed exchange rate

Proposition 6.4. In the M–F model of a fixed exchange rate,

fiscal expansion causes the following changes, provided
capital is not completely mobile:
• in the short run, a rise in the interest rate and income and
an overall surplus on the balance of payments (a net
reserve gain)
• in the long run, a further increase in income while the
interest rate falls somewhat and the overall balance of
payments surplus shrinks to zero, leaving a substantial
current account deficit.
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Mundell – Flaming Model
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6.7 The monetary model and the Mundell–
Fleming model compared

The differences can be considered under the

following three headings:

 Price level
 Income
 Expectations and interest rates
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6.7 The monetary model and the Mundell–Fleming model
compared

6.7.1 Price level

 In the monetary model, since the aggregate supply curve
is vertical at all times, the price level moves with perfect
flexibility to clear both money and goods markets. Then
PPP ensures that the real exchange rate is preserved at
its equilibrium level.
 In the M–F model, the price level is simply an exogenously
fixed index that can have no role to play in the domestic
macroeconomy. Neither can it play any part in determining
equilibrium in the open sector.
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6.7.2 Income
 In the monetary model, with full employment and perfectly
functioning factor markets, changes in real income can only
be exogenous events  the only role left for income to play
is in helping to determine the demand for real balances.
 An (endogenous) increase in income is associated with three
types of effect in this context;
 Insofar as it raises the demand for money, it leads to a rise in the interest
rate, other things being equal.
 By feeding back on to consumption (the Keynesian multiplier effect) it
boosts demand for goods and services.
 It is associated with a worsening current account via the marginal
propensity to import and reserve losses or currency depreciation.
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6.7.3 Expectations and interest rates

r = r* + Δset + ρ
- Stocks and flows

Savings ≡ I + G + B
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Mundell – Flaming Model -Summary
The M–F model is set in the context of a flat aggregate supply
curve (that is, a constant price level), the absence of PPP, less
than perfect capital mobility and static expectations.

• With a floating exchange rate, equilibrium requires the domestic money

and goods markets to clear, as in the IS–LM model, while in the open
sector the sum of the deficits on current and capital accounts is zero. The
latter condition ensures a balance of supply and demand in the currency
market

• With a floating exchange rate, expansionary monetary policy causes

depreciation and a fall in interest rates, while fiscal expansion has the
opposite effect.
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Mundell – Flaming Model -Summary
The M–F model is set in the context of a flat aggregate supply
curve (that is, a constant price level), the absence of PPP, less
than perfect capital mobility and static expectations.

• With a fixed exchange rate, expansionary monetary policy has the long-
run effect of causing a fall in the reserves, while fiscal expansion
produces a rise in income and the interest rate with a short-run reserve
gain.

• The M–F model contrasts with the monetary model in a number of

respects: its emphasis on the level of activity and interest rates rather
than the price level, its concentration on flows of spending and capital
movements rather than stocks of assets, and the central role it gives to
the crowding-out mechanism.