Hi, can someone please explain to me how and why this model works? I memorized when the currency appreciates/depreciates, but don’t understand it too well. Also, if you know how fixed-currency regime and floating-currency regime tie in, that would be great. Much appreciated, Jason

The main idea behind Mundell Fleming is that all else equal, high interest rates will make a given currency more attractive (think carry trade).

Mundell Fleming breaks down this interest rate effect into monetary and fiscal policy.

When monetary policy (think Federal reserve and the Ben Bernanke) is loosened, meaning the Fed wants to stimulate the economy, it usually does so by lowering interest rates, or undertaking activities that will lower the interest rate (e.g. buying bonds as per Operation Twist). The idea here is that cheaper money to borrow leads to more borrowing. If interest rates are lower, new lenders aren’t too happy because they can go to another country and lend at a higher rate.

When fiscal policy (think congress, think government spending) is loosened, meaning the government wants to stimulate the economy, the effect of these economic stimuli will lead to higher interest rates. More people wanting to buy and build stuff will lead to greater demand for capital, leading to higher cost of capital (interest rates). Companies see opportunities for growth and they are competing for capital from domestic and foreign lenders. This competition pushes rates up and lenders are in a powerful bargaining position.

So as you can see here, there are opposing forces on interest rates when you want to stimulate the economy, and this results in opposing forces on currency exchange rates.

In the first scenario, foreign investors aren’t going to be interested in investing as much, so they won’t be buying your currency, in fact if interest rates have gone down they’re likely to be exiting their positions to lock in their profits and that means selling your currency, leading to lower exchange rates.

In the second scenario, foreign investors are going to be jumping in on the bidding war for capital and that means they’ll be buying your currency, leading to higher exchange rates.

Now, about currency exchange regimes…

If the government doesn’t get involved in the FX market, supply and demand does its own thing. In scenarios where interest rates are being pushed in the same direction (expansionary monetary + contractionary fiscal, or vice versa) the confluence pushes exchange rates in a clear direction. In cases where there are opposing forces (expansionary fiscal + expansionary monetary and vice versa), exchange rates are pushed in contradictory directions and the effect can be uncertain.

If the government has a target exchange rate, that means they have to get involved in the FX market to alter supply/demand. So when they see a force moving the exchange rate one way, they start doing the opposite in order to enforce a balance.

If monetary policy is loosened, the exchange rate will begin to fall because foreign investors don’t want to lend when they get a bad return on capital. To counteract this, the government will begin buying its own currency and selling foreign currencies, to keep up the exchange rate. However, this messes things up from the perspective of money supply, by buying up your own currency (essentially boarding it up in the government’s FX reserves) you’re decreasing money supply, and that is the exact opposite of what you want to accomplish when you are doing expansionary monetary policy.

However, things move differently when taken from the perspective of fiscal policy. When you are loosening fiscal policy (encouraging economic activity) there is upward pressure on interest rates due to the competition for capital, and foreign investors are jumping in to take advantage of the yield (again, think carry trade). The government wants to counteract this upward pressure so it begins to massively sell its currency and buy foreign (think China buying t-bills denominated in USD). So when the government knocks its own currency back down, that is even better for economic expansion because your country’s exports will be more competitive (again, think China).

Hope this helps. There’s also capital mobility, but you specifically asked about MF and fixed/floating rates.

I figured I might as well finish what I started…

When you have high capital mobility, that means the government is chill with investors coming in to buy financial assets like bonds and stocks. This can be a problem, however, in emerging markets where foreign investors who hunt yield can create an asset bubble by rushing in to take advantage of attractive yield when emerging markets are in expansionary mode, and bidding up prices to unsustainable levels (think Brazil).

So, these emerging markets put in capital controls, meaning it will make it harder for hedge funds and the like to jump in and out of the market opportunistically. They usually like you to stay in an investment for a certain minimal amount of time, for example, taxing your gains heavily if you don’t hold to that. With such policies in place, you’re not going to get as much speculative acticity from the capital side, meaning the exchange rate won’t be heavily influenced by hedge fund charlie who is looking to buy bonds and stocks.

However, any government, esp. an emerging market, has an active market for its exports and still needs imports to function. So, even though they can control the inflow/outflow of capital, they still have to trade with the rest of the world, and that corridor of activity will influence the exchange rate.

Consequently in such situations we need to entirely focus on what’s happening with the exchange rate due to these trade flows; we are ignoring the attraction of higher yield by foreign investors since their ability to take advantage of that is limited with capital controls. If there is fiscal expansion, more people will be interested in buying imports (since they have greater desire to spend in general) which will cause your domestic currency to depreciate, as they are buying foreign currency to buy the foreign imports. The same thing happens with monetary expansion: cheaper interest rates leads to an economic stimulus, meaning we can afford more things, meaning we can afford more imports, meaning we buy foreign currency to buy imports, and our currency falls in relation to the foreign currency.

If you have an opposite pull with the trade balance, e.g. expansionary fiscal versus contractionary monetary, then the rate here is uncertain because you have two opposing forces and you can’t tell which one is stronger just like that.

When we didn’t have capital controls, interest rates were the predominant theme in exchange rates, so there we had to focus more on what interest rates were doing, not so much the trade balance.

Great, thanks for you very comprehensive answer!

Great explanation Giavanni !


Henning Hansen

this is very helpful explanation, thank you very much!

good god that was detailed.

you want to mention what you do for a living? I am curious to know.

You explained that better than BOTH Schweser and Elan.

This made my time today reviewing econ that wee bit easier.

Thank you Gio!