To quote Dornbusch and Fischer again, “Under fixed exchange rates and perfect capital mobility, a country cannot move out of line with those prevailing in the world market. Thus, with the perfect mobility of capital and given a fixed exchange rate, domestic interest rate has been pushed back to the initial level. This will lead to the increase in foreign exchange reserves with the Central Bank which will issue more national currency against the increase in foreign exchange reserves.Īs a result, money supply in the economy will expand causing the rate of interest to fall. To prevent the currency from appreciation, the Central Bank will buy the foreign currency, say US dollar. This will force the Central Bank of the country which is committed to maintain the exchange rate at the fixed level to intervene to prevent the appreciation of exchange rate of the national currency. This appreciation of the currency will discourage exports and encourage imports which would have an adverse effect on balance of payments. With a huge inflow of capital, foreign exchange rate of the domestic currency will rise, that is, the currency of the country that adopts a higher interest rate monetary policy will appreciate. When with the adoption of this policy interest rate rises in the economy, foreigners will shift their investible funds to this country so as to take advantage of the higher interest rate. ![]() Suppose Central Bank of a country tightens its monetary policy so as to raise interest rate in the economy. These changes in balance of payments will affect exchange rate between different national currencies which would eliminate interest rate differential. Under perfect mobility, a very small difference in interest rates in different countries would cause infinite capital flows that would bring about changes in balance of payments. Mundell-Fleming Model of the Small Open Economy with a Fixed Exchange Rate Regime: Impact of Monetary Policy:Īn important result of the Mundell-Fleming linkage model under fixed exchange rate regime is that a central bank of a country cannot pursue an independent monetary policy. These are some of the reasons due to which interest rates in different countries are not equal. Finally, countries adopt measures to restrict capital outflows or simply default in making payments. Secondly, exchange rates between different currencies can change, sometimes considerably, which affect return in dollars on foreign investment. First, there are tax differences among countries which hinder the mobility of capital in response to interest-rate differentials among countries. However, Mundell – Fleming Model is based on same conditions which do not prevail in the real world. Besides, in case of the variable exchange rate system, the equilibrium of the two markets also determine the exchange rate. The interest rate being given, the intersection of IS and LM curves determine the level of national income at which both the goods market and money market are in equilibrium. The price P and world interest rate (r 4) are the other exogenously given variables. G and Tare the variables determined by fiscal policy, M is the monetary policy variable and they are important exogenous variables. The IS equation describes the goods marks equilibrium and the second LM equation describes money market equilibrium. ![]() The Mundell-Fleming model of a small open economy with perfect capital mobility can be described by the following equations for IS and IM curves In what follows we first explain below Mundell-Fleming model when the economy operate under the fixed exchange rate system and then analyse the model when the economy has adopted the flexible exchange rate system. Another important aspect of Mundell-Fleming model is that behaviour of the economy depends on whether it adopts the fixed exchange rate system or flexible exchange rate system. The Mundell-Fleming model, with domestic interest rate determined by the world interest rate, focuses on the role of exchange rate in the determination of national income in the short run. Hence the equation r = r f represents that international flow of capital quickly brings the domestic interest rate equal to the world interest rate. On the other hand, if some event or policy causes domestic interest to exceed world interest rate, then the capital inflows would bring down the domestic interest rate to the level of world interest rate. If due to some event or economic policy domestic interest rate happens to be lower than the world interest rate, the capital outflows would drive the domestic interest rate back to the world interest rate. It is the perfect mobility of capital that makes domestic interest rate (r) equal to the world interest rate. Where r stands for domestic interest rate in the economy and r f is the world rate of interest.
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