Osborne’s bet on Mundell-Fleming

What's wrong with the Mundell-Fleming model? This question probably doesn't much pre-occupy the political class, but it should because it provides pretty much the only defence remaining for the coalition's macroeconomic policies.

What’s wrong with the Mundell-Fleming model? This question probably doesn’t much pre-occupy the political class, but it should because it provides pretty much the only defence remaining for the coalition’s macroeconomic policies.

The model predicts that, under certain conditions, fiscal policy has no effect upon output whereas monetary policy does. Here’s one of the battered textbooks of my youth:

In the Mundell-Fleming model a monetary expansion leads to an increase in output while a fiscal…expansion has no effect at all upon the level of output. (Dornbusch, Open Economy Macroeconomics, p195).

Yes, a tigher fiscal policy tends to weaken domestic demand. But the story doesn’t stop there. Weaker domestic demand reduces the demand for money, which tends to reduce interest rates, thus causing an incipient capital outflow, which reduces the exchange rate. And this raises net exports and offsets the fall in domestic demand. A monetary expansion exacerbates the downward pressure upon interest rates, thus forcing the exchange rate down further, which boosts output.

In the Mundell-Fleming model, then, “fiscal conservatism and monetary activism” is the right policy mix. To argue against Osborne, you must therefore reject this model. Can we do so?

You might think it’s simple, because the model uses a dubious LM curve. But I don’t think this is a clinching argument in our context because a key prediction of the model has been correct recently. Sterling has fallen – which suggests Mundell-Fleming is more relevant than, say, the Obstfeld-Rogoff model (pdf).

And Osborne’s supporters might add that if Mundell-Fleming is good enough for Krugman, it’s good enough for them.
Instead, I’d highlight several problems.

One is the time lag. Austerity hits output quickly, whilst exchange rate moves, at best, are slow to raise exports. This problem has been exacerbated by a failure of implementation; a serious monetary activist would not have waited three years to change the Bank of England’s remit.

A further problem is that there is sand in wheels, which prevent exchange rates having a large impact upon net exports.

The very volatility of exchange rates cause exporters and potential exporters to adopt a “wait and see” attitude; they only move in and out of markets if they expect an exchange rate move to be permanent. Globalized supply chains mean that exports have a large import content. Pricing to market and intra-multinational trade mean that the impact of currency moves on consumer prices is limited, and this limits the switch from imports to import-substitutes.

You could argue that these problems don’t invalidate Mundell-Fleming, but merely mean that we need a very large fall in sterling indeed.

But there are at least two reasons to doubt we’ll get this. One is simply that exchange rates are cussed little bastards that rarely move as macroeconomic models predict. Just as it’s silly to base asset allocation strategies upon exchange rate forecasts, so it’s silly to base economic policy upon them.

The other reason is that the UK is not the only country trying to be fiscal conservatives and monetary activists. So too are the US and euro area – though the latter is better at the conservative bit. Not all countries can have a depreciating currency. The global economy is closed, so Mundell-Fleming is irrelevant.

I suspect, then, that Mundell-Fleming doesn’t justify the coalition’s policies. This might explain why, AFAIK, none of its supporters have appealed to it.

Chris Dillow blogs at Stumbling and Mumbling

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