Limitations of the Mundell-Fleming Model Term Paper

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38). The Mundell-Fleming model is most graphically illustrated under the assumption of constant prices with the following three equations as shown in Figure 1 below.

E (Y, r) + NX (q, Y, Y*)

PL (Y, r)

NX - B (B, r, r *, q, q + ?) = 0.

Figure 1. The Mundell-Fleming model.

Note: All foreign values are indicated with an asterisk and are assumed to be exogenous; the sign of the partial derivative is denoted above each symbol.

Source: Bosworth, 1993, p. 37.

Notwithstanding it's the Mundell-Fleming Model's usefulness for certain applications are described above, it does have its constraints. According to Eichengreen and Frieden (2001), "The fixed vs. floating debate for Europe has largely been carried out (sometimes implicitly) in the context of the Mundell-Fleming model, so this model is the appropriate venue to consider the implications of local currency pricing. However, in this model, behavior is not based explicitly on optimization" (p. 92). These authors cite four fundamental limitations with the Mundell-Fleming Model:

Companies may hedge their exchange rate gains and losses in various ways; e.g., they might use derivatives to protect themselves from foreign exchange fluctuation.

In the alternative, some of their costs may be borne in the currency of the location where the good is sold; e.g., the firm might do some production or assembly in the buyer's country and at a minimum, marketing and distribution costs may be denominated in the buyer's currency in which case a change in the exchange rate changes costs and revenues in the same direction so that the impact on profits is diminished.

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The degree to which domestic firms are in part owned by foreigners (and vice versa), the effect of the exchange rate change on the relative income of domestic and foreign residents is mitigated.

In reality, owners may not possess complete information on how foreign exchange gains and losses affect the company's profits in the short run. As a result, individual firm owners may not treat short-run changes in profits from foreign exchange exposure the same as other income (Eichengreen & Frieden, 2001).

Conclusion

The research showed that basic focus of the Mundell-Fleming Model is a small open economy that is characterized by unemployed resources, a perfectly elastic aggregate supply curve, static exchange rate expectations and perfect capital mobility. If these assumptions are found to hold true, the model can provide useful insights concerning the inefficacy of fiscal policies for these purposes, but many experts have cited numerous constraints with the model since it was introduced. Given the dynamic nature of the international marketplace today, particularly as it regards small emerging nations with fragile economies, the Mundell-Fleming Model can provide analysts with some valuable information if the variables that are used are selected carefully and the results interpreted by keeping in mind the various limitations described above......

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