Macroeconomics

In conditions of perfect capital mobility and floating exchange rate fiscal policy is likely to be ineffective while monetary policy may be effective in achieving internal and external balance

This paper shall discuss the Mundell-Fleming Model as applied to a specific condition of floating exchange rates in an open small economy and perfect capital mobility, with special attention to how fiscal and monetary policies impact the macroeconomy. The writer shall attempt to test and explain the proposition that “fiscal policy is likely to be ineffective, while monetary policy may be effective, in achieving internal and external balance. "
The Mundell-Fleming model uses the Hicksian IS and LM framework to analyze the effectiveness of fiscal and monetary policies for small open economies under fixed and flexible exchange rates, assuming perfect capital mobility. The seed of the model is found in his published article (Mundell 1962), which later appeared in his book in 1968 and a collection of macroeconomics essays in 1970.
An attempt will be made to discuss some basic concepts relevant to the topic with the aim of leading the reader towards a clearer understanding of the premises and the relationships that underpin the effectiveness, or lack thereof, of fiscal and monetary policies in bringing about the desired changes that would result in an internal and external balance.
The problem faced by many economies concerns the achievement of internal stability and balance of payments equilibrium. Mankiw (1997) defines stabilization policy as public policy aimed at keeping output and employment at their natural rate levels. Fiscal and monetary policy can be used as instruments to attain these objectives if capital flow responds to differences in interest rates among the economies. An appropriate policy mix should be one where a country with balance of payments surplus and facing inflationary pressures will attempt to ease the monetary situation through selling in open market operations and at the same time raising taxes, thereby reducing money supply. A deficit country with unemployment problem or less than full employment will reduce

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