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international capital flows. The vast majority of Mundell’s work over his lifetime has been on some aspect of trade or capital flows.
One of the first major questions Mundell addressed was how governments should stabilize economies—keeping them growing while avoiding high inflation—in a world of trade and capital flows. He showed that when the exchange rate is fixed, as it was throughout the 1950s and 1960s between all major trading countries, stabilizing the economy with monetary policy is futile. The reason is that a government that fixes its exchange rate against other currencies must be prepared to provide whatever amount of money is demanded at this fixed price. This means that monetary policy is essentially passive. A government that wants to stabilize the economy must thus use fiscal policy—that is, changes in taxes or government spending.
Mundell also considered the case of floating exchange rates. At the time this was regarded as a theoretical curiosum because, as mentioned, all major trading countries had fixed their exchange rates with each other. But Mundell’s native Canada had floated its dollar from 1950 to 1962. Possibly for that reason, and possibly because Mundell had a sense of the future, he thought it worthwhile to consider the floating exchange rate case. (Major countries’ exchange rates have floated since the early 1970s.) Mundell showed that if the country has a floating exchange rate, then the government has much more ability to use monetary policy. On the other hand, fiscal policy now becomes impotent. If the government wants to increase aggregate demand by increasing government spending, for example, then, if it does not change monetary policy, the increase in the exchange rate due to the increase in aggregate demand reduces exports. Thus, all fiscal policy can do is change the composition of aggregate demand, not its level. The model Mundell used in 1960 to show this is now called the Mundell-Fleming model, after Mundell and Marcus Fleming,1 who developed a similar, though less extensive, model around the same time.
Mundell also did some early work in what is now known as “the monetary approach to the