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The Effects of Stabilization Policy
In several papers published in the early 1960s – reprinted in his book International Economics (1968) – Robert Mundell developed his analysis of monetary and fiscal policy, so-called stabilization policy, in open economies.
The Mundell-Fleming Model
A pioneering article (1963) addresses the short-run effects of monetary and fiscal policy in an open economy. The analysis is simple, but the conclusions are numerous, robust and clear. Mundell introduced foreign trade and capital movements into the so-called IS-LM model of a closed economy, initially developed by the 1972 economics laureate Sir John Hicks. This allowed him to show that the effects of stabilization policy hinge on the degree of international capital mobility. In particular, he demonstrated the far-reaching importance of the exchange rate regime: under a floating exchange rate, monetary policy becomes powerful and fiscal policy powerless, whereas the opposite is true under a fixed exchange rate.
In the interesting special case with high capital mobility, foreign and domestic interest rates coincide (given that the exchange rate is expected to be constant). Under a fixed exchange rate, the central bank must intervene on the currency market in order to satisfy the public’s demand for foreign currency at this exchange rate. As a result, the central bank loses control of the money supply, which then passively adjusts to the demand for money (domestic liquidity). Attempts to implement independent national monetary policy by means of so-called open market operations are futile because neither the interest rate nor the exchange rate can be affected. However, increased government expenditures, or other fiscal policy measures, can raise national income and the level of domestic activity, thereby escaping the impediments of rising interest rates or a stronger exchange rate.
A floating exchange rate is determined by the market since the central bank refrains from currency intervention. Fiscal policy now becomes powerless. Under unchanged monetary policy, increased government expenditures give rise to a greater demand for money and tendencies towards higher interest rates. Capital inflows strengthen the exchange rate to the point where lower net exports eliminate the entire expansive effect of higher government expenditures. Under floating exchange rates, however, monetary policy becomes a powerful tool for influencing economic activity. Expansion of the money supply tends to promote lower interest rates, resulting in capital outflows and a weaker exchange rate, which in turn expand the economy through increased net exports.
Floating exchange rates and high capital mobility accurately describe the present monetary regime in many countries. But in the early 1960s, an analysis of their consequences must have seemed like an academic curiosity. Almost all countries were linked together by fixed exchange rates within the so-called Bretton Woods System. International capital movements were highly curtailed, in particular by extensive capital and exchange rate controls. During the 1950s, however, Mundell’s own country – Canada – had allowed its currency to float against the US dollar and had begun to ease restrictions. His far-sighted analysis became increasingly relevant over the next ten years, as international capital markets opened up and the Bretton Woods System broke down.
Marcus Fleming (who died in 1976) was Deputy Director of the research department of the International Monetary Fund for many years; he was already a member of this department during the period of Mundell’s affiliation. At approximately the same time as Mundell, Fleming presented similar research on stabilization policy in open economies. As a result, today’s textbooks refer to the Mundell-Fleming Model. In terms of depth, range and analytical power, however, Mundell’s contribution predominates.
The original Mundell-Fleming Model undoubtedly had its limitations. For instance, as in all macroeconomic analysis at the time, it makes highly simplified assumptions about expectations in financial markets and assumes price rigidity in the short run. These shortcomings have been remedied by later researchers, who have shown that gradual price adjustment and rational expectations can be incorporated into the analysis without significantly changing the results.
Monetary Dynamics
In contrast to his colleagues during this period, Mundell’s research did not stop at short-run analysis. Monetary dynamics is a key theme in several significant articles. He emphasized differences in the speed of adjustment on goods and asset markets (called the principle of effective market classification). Later on, these differences were highlighted by his own students and others to show how the exchange rate can temporarily “overshoot” in the wake of certain disturbances.
An important problem concerned deficits and surpluses in the balance of payments. In the postwar period, research on these imbalances had been based on static models and emphasized real economic factors and flows in foreign trade. Inspired by David Humes’s classic mechanism for international price adjustment which focused on monetary factors and stock variables, Mundell formulated dynamic models to describe how prolonged imbalances could arise and be eliminated. He demonstrated that an economy will adjust gradually over time as the money holdings of the private sector (and thereby its wealth) change in response to surpluses or deficits. Under fixed exchange rates, for example, when capital movements are sluggish, an expansive monetary policy will reduce interest rates and raise domestic demand. The subsequent balance of payments deficit will generate monetary outflows, which in turn lower demand until the balance of payments returns to equilibrium. This approach, which was adopted by a number of researchers, became known as the monetary approach to the balance of payments. For a long time it was regarded as a kind of long-run benchmark for analyzing stabilization policy in open economies. Insights from this analysis have frequently been applied in practical economic policymaking – particularly by IMF economists.
Prior to another of Mundell’s contributions, the theory of stabilization policy had not only been static, it had also assumed that all economic policy in a country is coordinated and assembled in a single hand. By contrast, Mundell used a simple dynamic model to examine how each of the two instruments, monetary and fiscal policy, should be directed towards either of two objectives, external and internal balance, in order to bring the economy closer to these objectives over time. This implies that each of two different authorities – the government and the central bank – is given responsibility for its own stabilization policy instrument. Mundell’s conclusion was straightforward: to prevent the economy from becoming unstable, the linkage has to accord with the relative efficiency of the instruments. In his model, monetary policy is linked to external balance and fiscal policy to internal balance. Mundell’s primary concern was not decentralization itself. But by explaining the conditions for decentralization, he anticipated the idea which, long afterwards, has become generally accepted, i.e., that the central bank should be given independent responsibility for price stability.
Mundell’s contributions on dynamics proved to be a watershed for research in international macroeconomics. They introduced a meaningful dynamic approach, based on a clear-cut distinction between stock and flow variables, as well as an analysis of their interaction during the adjustment of an economy to a stable long-run situation. Mundell’s work also initiated the necessary rapprochement between Keynesian short-run analysis and classical long-run analysis. Subsequent researchers have extended Mundell’s findings. The models have been extended to incorporate forward-looking decisions of household and firms, additional types of financial assets and richer dynamic adjustments of prices and the current account. Despite these modifications, most of Mundell’s results stand up.
The short-run and long-run analyses carried out by Mundell arrive at the same fundamental conclusion regarding the conditions for monetary policy. With (i) free capital mobility, monetary policy can be oriented towards either (ii) an external objective – such as the exchange rate – or (iii) an internal (domestic) objective – such as the price level – but not both at the same time. This incompatible trinity has become self-evident for academic economists; today, this insight is also shared by the majority of participants in the practical debate.