Mundell–Fleming

Thanks to the work of Robert Mundell and J. Marcus Fleming we know that certain combinations of monetary and fiscal policy create specific exchange rate conditions. The Mundell–Fleming model illustrates how specific combinations of monetary and fiscal policy changes can cause temporary changes in the balance of payments relative to an equilibrium level. The exchange rate therefore becomes the transmission mechanism by which equilibrium is restored to the balance of payments. It must be noted within this that the degree of capital mobility is crucially important.
In an economy with high capital mobility, suppose that a central bank decides to loosen monetary policy by cutting interest rates. One must assume that it does this because of weak growth conditions and benign inflation. As we saw before when looking at money demand, lowering interest rates reduces the incentive to hold interest-bearing securities, thus on a relative basis increasing the incentive to hold money or cash. This increase in money demand can be put to work buying goods and should reflect a future rise in national income and growth. The standard monetary model thinks of this in terms of rising demand causing price increases, which in turn causes the exchange rate to depreciate via the concept of PPP. Looking at it another way, rising domestic demand will cause rising import demand, which should mean deterioration in the trade balance. This in turn should eventually lead to depreciation in the exchange rate to allow the trade balance to revert back towards an equilibrium level. Another way of expressing the same thing is that lower interest rates cause capital outflows, which in turn cause depreciation in the exchange rate. Conversely, the basic assumption is that tighter monetary policy through higher interest rates should lead either to weaker domestic demand and a positive swing in the trade balance, or capital inflows, both of which should cause exchange rate appreciation.
On the fiscal side, much depends on whether trade or capital flows dominate. On the one hand, looser fiscal policy, either through tax cuts or spending increases, should cause rising domestic demand, which in turn should cause deterioration in the trade balance. On the other hand, looser fiscal policy causes higher domestic interest rates, which in turn attract capital inflows. If trade flows dominate, then the exchange rate should depreciate. However, if capital flows dominate, then the exchange rate should appreciate.
Conversely, tighter fiscal policy should, according to Mundell–Fleming, lead to weaker domestic demand. On the trade flow side, this should result in reduced import demand, causing a positive swing in the trade balance. On the capital flow side, tighter fiscal policy should lead to lower interest rates, which in turn lead to capital outflows. Here, if trade flows dominate, the exchange rate should appreciate, whereas if capital flows dominate, the exchange rate should depreciate. In a world of perfect or at least high capital mobility, it is assumed that capital flows dominate over trade flows.
This model can be used for developed economies and the leading emerging market economies which have deregulated and liberalized barriers to trade and more importantly capital. The classic example of this used in text books is that of the US dollar in 1980–1985, when it appreciated dramatically as the Reagan administration’s military spending programme dramatically boosted the budget deficit, while the Volcker-led Federal Reserve waged war against inflation (caused at least in part by those budget deficits). The Plaza Accord of 1985, which helped to bring down the value of the US dollar, worked only because it was accompanied by significant policy changes. In the 1993–1995 period, the US had a somewhat different problem to 1980–1985. While the new US government was moving towards the idea of balancing the budget, and thus tightening fiscal policy, the Federal Reserve was in 1993 keeping a relatively loose monetary policy. Indeed, one could argue that the Fed maintained an inappropriately loose monetary policy for much of 1994 up until its tightening of November 1994, before policy was seen as appropriately tight. Perhaps not coincidentally, in 1994 the US Treasury market had its worst year on record. In line with this, the US dollar weakened up until November of that year. The above model and examples assume either perfect or high capital mobility. However, not all economies are like this. While the move towards liberalization of trade and capital has broadly increased capital mobility, there remain specific countries in the emerging markets where capital mobility remains low (e.g. China). In this case, therefore, one must assume that trade flows dominate over capital flows.
The Mundell–Fleming model has done much to explain how combinations of monetary and fiscal policy should affect exchange rates. Indeed, their model is the standard for this kind of work.