Emerging Asia’s Version of the Mundell-Fleming Model

doi:10.4236/me.2013.49064

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Modern Economy, 2013, 4, 596-599

http://dx.doi.org/10.4236/me.2013.49064 Published Online September 2013 (http://www.scirp.org/journal/me)

Emerging Asia’s Version of the Mundell-Fleming Model

Suresh Ramanathan*, Kian Teng

Economics Department, Faculty of Economics and Administration, University Malaya, Kuala Lumpur, Malaysia

Email: *[email protected], [email protected]

Received July 17, 2013; revised August 7, 2013; accepted August 13, 2013

tion License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly

cited.

ABSTRACT

This paper explains the Mundell-Fleming model in the context of Emerging Asia economies management of capital

mobility. Central Banks and Financial Regulators in Emerging Asia adopt a modified version of the model that incor-

porates two vital levers, a policy driven and a market driven method that is adaptable to the magnitude of capital flow.

A policy combination mix of both policy and market driven provides smooth monetary policy signal transmission to

exchange rates.

Keywords: Mundell-Fleming Model; Capital Mobility; Foreign Exchange Markets; Monetary Policy; Emerging Asia

1. Introduction

Stable exchange rates, independent monetary policy and

free capital flow, the trilemma or impossible trinity, sug-

gest that only two of the above three objectives can be

accomplished simultaneously according to Fleming and

Mundell (1962 and 1963) [1,2]. In assessing the trilemma,

findings by Mankiw (2010) [3] indicate China managed

to achieve stable exchange rates and independent mone-

tary policy that was accompanied by capital controls. But

can the trilemma be considered as a guide for macroeco-

nomic policy framework? Obstfeld et al. (2005) [4] sug-

gest economies that are without a pegged exchange rate

and have barriers to capital mobility can retain sufficient

amount of monetary policy independence whereas

economies with pegged exchange rates and do not have

barriers to capital mobility would lose significant mone-

tary policy independence. In a case study by Yu Hsing

(2012) [5] on selected EA economies, findings in support

of trilemma were evident in Malaysia, Philippines and

Singapore, while there was no evidence of a trilemma

situation in Indonesia and Thailand. Different macro-

economic policy combinations prevailed in Malaysia,

Philippines and Singapore, rendering the ability to switch

to different policy combination over time in order to deal

with major economic events. In conceptualizing the

Mundell-Fleming model within the trilemma objective, it

is pertinent to take into account the risk premium element

in the form of barriers to capital mobility. In EA foreign

exchange markets, barriers to capital mobility play a sig-

nificant role in managing the overall macroeconomic

policy framework. There are two key aspects of the EA

version of the Mundell-Fleming model, the market and

policy-driven space.

2. The Model

The Mundell-Fleming model for EA incorporates mar-

ket-driven, D point and policy-driven. E point (see Fig-

ure 1).

In the context of the standard model, points A, B and C

remain, indicating the choice for central banks and finan-

cial regulators being limited to adhering only two points

of preference, where the distance between A to C being

exchange rate fixing, A to B as monetary policy inde-

pendence and B to C as free capital mobility. In EA a

strict proposition of the Mundell Fleming model is a

constrain for central banks and financial regulators fol-

lowing the lessons learnt during the 1997/98 Asian Fi-

nancial Crisis. Consistent with this objective, Aizenman

et al. (2011a) [6] finds that for developing economies,

maintaining exchange rate stability was a key priority up

to the period of 1990, and since 2000, developing

economies pursued managed exchange rate flexibility

and retained partial monetary policy independence. The

task of managing capital mobility is to keep it in line

within the macroeconomic policy framework of the do-

mestic economy, therefore, the introduction of points D

and E. The midpoint of D to E is a policy combination

mix where the degree of capital mobility between A to D

*Corresponding author.

pen Access ME

S. RAMANATHAN, K. TENG 597

Market driven space

Ful l capita l mobi li ty

Tight l y Fixe d exch ang e rate

D - B

Degre e of Monet ary P olicy in de penden c e

D – C

Degree of exchange rate fixin g

Free capital mobility

Freely Floating exchange rate

Policy driven space

A - B

Monetary Po lic y

indep en d en ce

A - C

Exchange rate

fixing

No capital

mobility

D – A

Degree of

capital

mobility

D – E

Policy

combination

mix

Figure 1. Emerging Asia Mundell-Fleming model.

is adjusted using the policy combination mix. The man-

agement of capital flow in EA financial markets though

is within the same plane of A and E, the adjustment

process for central banks and financial regulators is done

via the distance between D to E. As E stays as the centre

of the Mundell-Fleming model, the point E would inter-

face with points D and A. The flow of policy is captured

between a no capital mobility point of A or a full capital

mobility point of D (see Figure 2).

In both extreme cases, point E plays an integral role of

adjusting the policy-driven space. The policy combina-

tion mix takes into account the external and internal en-

vironment and the adjustment is done accordingly.

Within the framework of the Mundell-Fleming model

and taking into account of points A, D and E, the distor-

tion to capital mobility in the EA framework is identified

by incorporating risk premium on capital mobility. Risk

premium in the form of barriers to capital mobility ṕ

which is the the interest rate that onshore investors must

pay to foreign investors. The risk-free rate in the eco-

nomy, ᶉ is the premium that foreign investors must pay to

domestic investors for parting with liquidity. In the

Mundell-Fleming model, ᶉ is determined in the money

market for a given real output, prices, and money supply.

Given the risk premium, the exchange rate e incorporates

ṕ, implying barrier of capital mobility that foreign inves-

tors face in investing in the domestic financial market.

Therefore risk premium

ṕ = f (ᶉ,e). (1)

where fᶉ > 0 and fe > 0. Higher interest rates ᶉ in the case

of tightening of monetary policy in the economy results

in an increase in the capital mobility risk premium

Mark et driven spac

Full capital mobility

No capital

mobility

Policy driven space

Figure 2. Market driven, policy driven, capital mobility.

ṕ and depreciation of the exchange rate is priced into the

capital mobility risk premium. As e increases it is identi-

fied as exchange rate depreciation and as e decreases it is

identified as exchange rate appreciation.

The model incorporates aggregate demand and supply

as reflected by the IS curve, given as

Y = D(Y, ᶉ, e) + G + NX(Y,e) (2)

where,

DNX



 (3)

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S. RAMANATHAN, K. TENG

598

If, e < ê

The equilibrium in the money market is reflected by

the LM curve as

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and other high, referred as e and e. The two vertical

M/P = L(ᶉ, Y)

(4)

The price level P is an exogenous component while

monetary policy is conducted by changing the money

supply M.

The balance of payments or the BP curve is identified

BP = NX(Y, e) + KA(ᶉ − r*, ṕ − ṕ* ) (5)

where,

epe

NXKA p (6)

If e > ê

where r* and ṕ* is the interest rate and risk premium at

equilibrium, whereby

KAᶉ + KAppᶉ > 0 (7)

If ᶉ < r*

And net exports NX have a positive relationship be-

tween income Y and the exchange rate e.

In the Mundell-Fleming model, capital flows KA in-

crease when interest rate differentials ᶉ − r* widen. Gray

and Malone (2008) [7] indicate, in the case of risk pre-

mium differences ṕ − ṕ* which widens, capital flow will

decrease given the risk of decline in investments and

general risk aversion to investments.

The standard BP model in the Mundell-Fleming model

while applies in a free capital mobility framework is in-

stead curved in the context of EA financial markets when

it incorporates points A, D and E. Given the backward

bending BP curve, two equilibriums exists for each value

of the exchange rate when taking the IS curve as fixed.

The first equilibrium at point F occurs when ᶉa < r* at the

lower half of the BP curve and the second equilibrium is

at point G when ᶉb > r* at the upper half of the BP curve

(see Figure 3).

Appropriate fiscal and monetary policy is used to ob-

tain any point along the BP curve but it will be impossi-

ble to achieve a level of output higher than point H on

the BP curve without causing exchange rate depreciation.

For a given exchange rate ê , the money supply necessary

to obtain point F equilibrium is by MA(ê), and the money

supply necessary to obtain point G equilibrium is by

MB(ê). Caballero and Panageas (2005) [8] indicate that

the backward bending IS curve occurs if households

practice precautionary savings and reduce consumption

in response to capital mobility risk premium being in-

corporated into the exchange rate. Corresponding with

the ISBP curve, equilibrium in the output and foreign

exchange market comprises of two backward bending

curves. In such circumstances with fiscal and monetary

policy, two equilibrium exchange rates exists, one low

L H

ᶉ

BP < 0

BP > 0

BP < 0

BP > 0

BP < 0

LM (M =M

)) LM (M =M

))

ISB

ᶉ

Figure 3. Changes in monetary policy and risk of exchange

nes of the LM curve is consistent with monetary poli-

rate disequilibrium.

cies of





Me (8)

and



Me (9)

The arrows on the LM curve indicate the

onetary policy corre-

direction of

ovement of exchange rates that is out of equilibrium

where the space left of the ISBP curve intersects in two

places with the G equilibrium on the LM curve, the BP <

0, and exchange rates are increasing. In the space be-

tween the left hand and right hand of the ISBP curve, the

BP > 0, exchange rates are decreasing. To the right of the

right hand of the ISBP curve which intersects in two

places with F equilibrium on LM curve, the BP < 0 and

exchange rates are increasing.

In an environment of tight m

onding with M = MB and ᶉb > r*, the stable equilibrium

for exchange rates is at eH, but is unstable for exchange

S. RAMANATHAN, K. TENG

Open Access ME

599

3. Conclusion

l mobility being a factor that sh

REFERENCES

[1] J. M. Flemingolicies under Fixed

rate eL which indicates as monetary policy is tightened

and given the risk premium to capital mobility, main-

taining an exchange rate appreciation will be difficult. In

the case of easing of monetary policy with M = MA and ra

< r*, the stable equilibrium for exchange rates is at eL but

is unstable for exchange rate eH as excessively loose

monetary policy could induce a currency crisis.

In EA with capitaapes

macroeconomic prudential policies, the risk of tightening

and loosening of monetary policy bears a significant im-

pact on the direction of exchange rates. The importance

of the Mundell Fleming Model in the context of EA is

twofold. First, the imposition of barriers to capital mobil-

ity could amplify the impact on exchange rates when

monetary policy is tightened or loosened. Second, the

risk premium on capital mobility can be reduced gradu-

ally by carefully implementing a policy combination mix

in order to transmit smooth monetary policy signal to

exchange rates.

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