Mundell-Fleming Model

The Mundell-Fleming (M-F) model adheres to the Keynesian tradition that it is aggregate supply that takes the passive role of fixing the price level, while aggregate demand variations determine the level of economic activity.  It was highly influential in the 1960’s, particularly in policymaking circles, not least because it focuses mainly on normative questions relating to the optimal combination of monetary and fiscal measures for demand management in an open economy. The Mundell-Fleming model has important policy implications, which were treated together with the description of the model in the original writings of the two authors.  For didactic purposed we shall separate the descriptive and normative aspects. It should be pointed out that the Mundell-Fleming model is really not a pure flow model, since adjustments in the money stock play a role, indirectly affecting the balance of payments through their effects on the interest rate and hence on capital movements and real output.  However, the view of capital movements, which play a crucial role in the adjustment process, is still a pure flow view.  The model can be reduced to three equations, one which expresses the determination of national income in an open economy, one which expresses the equilibrium in the money market and the third which expresses balance-of-payments equilibrium.  The M-F model is set in the context of a flat aggregate supply, the absence of PPP, less than perfect capital mobility and static expectations.  With a floating exchange rate, equilibrium requires the domestic money and goods market 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.  The M-F model contrasts with the monetary model in a number of respects; in 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.