MUNDELL FLEMING MODEL

CONSTITUENTS OF THE MODEL

FIRMS HOUSEHOLDS GOVERNMENT REST OF THE WORLD (FOREIGN COUNTRY)

ROLE OF FIRMS
PRODUCTIVE ACTIVITIES INVESTMENT ACTIVITIES BY PURCHASING OTHER FIRMS OUTPUT FOR USE IN FUTURE PRODUCTION MAINTAIN INVENTORIES AS PER REQUIREMENTS

ROLE OF HOUSEHOLDS
OWN THE FIRMS AND HENCE THE FIRMS INCOME CONSUME SAVE IN (I) LIQUID MONEY (II) INTEREST BEARING BONDS

ROLE OF GOVERNMENT
PURCHASES FIRMS OUTPUT FOR CONSUMPTION LEVIES TAXES FOR FINANCING PURCHASES ACTION OF GOVERNMENT EXOGENEOUS TO THIS MODEL

ROLE OF ROW
THIS A TWO COUNTRY MODEL ROW SERVES THE ROLE OF FOREIGN COUNTRY

MARKETS IN THE MODEL

THE GOODS MARKET THE MONEY MARKET THE FOREX MARKET

ASSUMPTIONS
A TWO COUNTRY MODEL IN THE SHORT RUN, PRICES ARE FIXED IN RESPECTIVE CURRENCIES OF PRODUCTION GOVERNMENT ACTIONS ARE EXOGENOUS TRADE BALANCE=CURRENET ACCOUNT BALANCE HC HAS NO IMPACT ON ROW VARIABLES IN THE SHORT RUN HC OUTPUT NOT NECESSARILY EQUAL TO POTENTIAL OUTPUT

ASSUMPTIONS CONTD.
FULL CAPITAL MOBILITY - NO CAPITAL CONTROLS BY GOVERNMENT - FULL SUBSTITUTABILITY BETWEEN HC AND FC INSTRUMENTS BONDHOLDERS ARE RISK NEUTRAL HC PRODUCES A SINGLE GOOD X AND FC PRODUCES A SINGLE GOOD Q

THE GOODS MARKET

THE CONSUMPTION FUNCTION (C) FUNCTION OF DISPOSABLE INCOME W=Y-T SINCE CONSUMPTION INCREASES WITH W C(W)>0; 0<C(W)<1 C(W) IS CALLED MARGINAL PROPENSITY TO CONSUME(MPC) MPC REPRESENTS THAT PORTION OF MARGINAL INCOME THAT IS USED UP IN CONSUMPTION BY HOUSEHOLDS

THE INVESTMENT FUNCTION

FIRMS ENGAGE IN INVESTMENT PROJECTS ONLY IF REAL EXPECTED RETURN > EXPECTED BORROWING COST FIRMS EXPECTED BORROWING COST= EXPECTED REAL INTEREST RATE= EXPECTED NOMINAL INTEREST RATE INFLATION SINCE PRICES ARE FIXED IN SHORT RUN, INFLATION =0 HENCE REAL RATE = NOMINAL RATE

 THE GREATER THE DIFFERENCE BETWEEN MARGINAL PRODUCT OF CAPITAL AND AND THE REAL INTEREST RATE, MORE THE FIRMS WOULD WANT TO INVEST IN THE SHORT RUN, MP OF CAPITAL IS CONSTANT, HENCE, INVESTMENT WOULD INCREASE WITH FALL IN INTEREST RATES

I(i)<0

TRADE BALANCE
HIGHER FOREIGN DISPOSABLE INCOME W* INCREASES EXPORTS TB INCREASES HIGHER DOMESTIC DISPOSABLE INCOME W INCREASES IMPORTS TB DECREASES EXPENDITURE SWITCHING IF REAL EX RATE e = EP*/P INCREASES, PRICE OF FOREIGN GOODS INCREASES CONSUMERS SWITCH FROM FOREIGN TO HOME GOODS IMPORTS DECREASE TB INCREASES

HENCE TB=TB(e=EP*/P, W, W*)

dTB/de >0 dTB/dW <0 dTB/dW*>0

GOODS MARKET EQUILIBRIUM

GOODS MARKET EQUILIBRIUM IS ACHIEVED BY EQUATING THE GOODS MARKET AGGREGATE DEMAND D=C+I+G+TB TO THE AGGREGATE SUPPLY (Y)=GDP i.e. Y=D=C+I+G+TB

FACTORS THAT SHIFT DEMAND CURVE

D=C(Y-T)+I(i)+G+TB(e=EP*/P, Y-T, Y*-T*) FALL IN TAXES RISE IN GOVT SPENDING FALL IN HOME INTEREST RATE RISE IN NOMINAL EX RATE UPWARD SHIFT IN CONSUMPTION FUNCTION INVESTMENT FUNCTION TRADE BALANCE

FOREX MARKET
FOREX MARKET EQUILIBRIUM IS SET BY UNCOVERED INTEREST RATE PARITY i=i*+ (Ee-E)/E DR/FR FR DR

EQUILIBRIUM IN GOODS+FOREX MKTS THE IS CURVE

THE GOODS MARKET EQUILIBRIUM IS Y=C(Y-T)+I(i)+G+TB(e=EP*/P, Y-T,Y*-T*) THE FOREX MARKET EQUILIBRIUM IS THE UIRP i=i*+ (Ee-E)/E ELIMINATING E BETWEEN THESE EQS. WE GET Y=C(Y-T)+I(i)+G+TB(EeP*/P(1+i-i*), Y-T,Y*-T*) A PLOT BETWEEN THE THE OUTPUT Y AND THE DOMESTIC INTEREST RATE IS CALLED THE IS CURVE

THUS THE IS SHOWS THE COMBINATIONS OF OUTPUT AND INTEREST RATES AT WHICH THE GOODS MARKET AND THE FOREX MARKET ARE IN SIMULTANEOUS EQUILIBRIUM, GIVEN A SET OF EXOGENOUS CONDITIONS

DOWNWARD SLOPE OF THE IS CURVE

CONSIDER A DECREASE IN INTEREST RATE I THIS WILL INCREASE OUTPUT THROUGH TWO CHANNELS VIZ. CHANNEL A i (-) -> I(i) (+) -> DEMAND D (+) -> Y (+) CHANNEL B i(-) -> DR (-) -> E(+) TB (+) -> D(+) -> Y(+) HENCE DECREASE IN INTT INCREASES OUTPUT

FACTORS THAT SHIFT THE IS CURVE

FALL IN TAXES RISE IN GOVT SPENDING RISE IN FOREIGN INTEREST RATE RISE IN EXPECTED FUTURE EXCHANGE RATE UPSHIFT IN CONSUMPTION/ INVESTMENT/ TRADE BALANCE FUNCTIONS ANY OTHER EXOGENOUS CHANGE IN DEMAND

MONEY MARKETS DEMAND FOR MONEY

REAL MONEY DEMAND VARIES - DIRECTLY WITH OUTPUT MORE OUTPUT MEANS MORE REQUIREMENTS FOR CONSUMPTION AND FOR EXECUTING MONETARY TRANSACTIONS - INVERSELY WITH THE NOMINAL INTEREST RATE - MD=L(i)Y L(i) IS THE LIQUIDITY PREFERENCE FUNCTION

SUPPLY OF MONEY
SUPPLY OF MONEY IS FIXED BY THE MONETARY AUTHORITY AND HENCE IS CONSIDERED EXOGENOUS

MONEY MARKET EQUILIBRIUM

THE EQUILIBRIUM CONDITION IN MONEY MARKETS IS REAL MONEY SUPPLY = REAL MONEY DEMAND MS/P=MD/P=L(i)Y WITH dMD/di <0

INTEREST RATE MS/P

MD/P M/P

THE LM CURVE
THE LM CURVE GRAPHS THE RELATION BETWEEN OUTPUT Y AND THE INTEREST RATE i IN THE MONEY MARKETS THE LM CURVE IS UPWARD SLOPING WHEN OUTPUT Y INCREASES MONEY DEMAND MD INCREASES AT ALL INTEREST RATES SO MD SHIFTS UPWARDS SINCE MS IS FIXED INTT RATE RISES THUS THERE IS POSITIVE CORRELATION BETWEEN Y AND i

 AN INCREASE IN MONEY SUPPLY BY THE MONETARY AUTHORITY SHIFTS THE LM CURVE DOWNWARDS SINCE THERE IS NO CHANGE IN OUTPUT