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balance of payments,” which was actually laid out in rudimentary fashion by eighteenth-century economist David Hume. Mundell showed how, with fixed exchange rates, an economy will adjust as balance-of-payments surpluses or deficits cause changes in the money supply. Assume, for example, that capital moves across borders slowly. Then assume that the Federal Reserve increases the domestic money supply to reduce interest rates. With interest rates lower, domestic spending increases and imports increase. The resulting balance-of-payments deficit will cause money to leave the country, which in turn will cause domestic demand to fall, bringing the balance of payments back toward equilibrium. The net long-term result is a higher price level and no real economic effects.
Mundell also considered which government policy “tool” should be used on which policy “target.” He showed, contrary to what many economists before him had believed, that when exchange rates are fixed, monetary policy should be used to ensure equilibrium in the balance of payments (also known as the “external balance”), and fiscal policy should be used to adjust aggregate demand to attain full employment (“internal balance”).
In thinking through all these issues of assigning tools to targets and of fixed versus floating exchange rates, Mundell pointed out the so-called incompatible trinity: (i) unregulated mobility of capital, (ii) a particular fixed exchange rate, and (iii) a particular price level. Mundell showed that, at most, only two of these can be achieved. This has become standard thinking among economists and policymakers. It means that a government that wants, say, to keep inflation low and allow free capital movement must settle for a floating exchange rate, which is what most governments now do most of the time.
Mundell’s other big idea in the 1960s involves optimum currency areas. Rather than take it as given that each country should have its own currency, Mundell noted that if states within countries all shared the same currency, more than one country could do the same. Again, this seemed like a theoretical curiosum at the time (1961), but as the history of the euro has shown, it is anything but.
Mundell cited the reduction in transactions costs for trade across borders and the related ease of knowing various prices as the major advantages of a currency area (see