Mundell Fleming Model of Exchange Rates

The monetary model is better for a long run explanation of exchange rates. It assumes full employment with flexible prices. Furthermore, real income can be exogenously decided which determine the demand for real balances. However, Mundel Fleming model is better for short run explanation of exchange rates, where the price level is simply an exogenously fixed index while income is an endogenous variable. Since Mundel Fleming discusses the short run implications, it does not assume PPP, unlike monetary models.

The balance of payments summarises a country's transactions with the rest of the world.
Balance of Payments = Current Account + Capital Account + Official Reserves
1. Current Account = Trade balance + net investment income + net transfers
2. Capital Account = Capital flow - Capital outflow

Here, we focus on the goods market i.e. only the current account. Additionally, in Current Account, the Trade balance is the major component and therefore we will focus the attention to it.

So, the demand for domestic in an open economy would be:

where C is consumption (a function of disposable income), I is an investment (a function of income and real interest rate), G is government expenditure (exogenous), X is exports and Q(IM) is imports denominated in home country goods. 

Note that Q is the real exchange rate defined as the price of foreign goods in home country goods. So if Q>1, then domestic goods are cheaper than foreign goods. Further, an increase in Q would represent home country depreciation of the real exchange rate.

So, the determinants of net exports are:

It can be seen that the real exchange rate affects net exports through 3 channels. So, if Q increases or home country depreciation of the real exchange rates then,

1. exports (X) increases

2. Import (IM) decreases

3. Import bill (Q(IM)) increases

If 1 and 2 are larger than 3, then a real depreciation leads to an improvement in the trade balance. Therefore, the Marshall-Lerner condition is the condition under which real depreciation leads to an increase in net exports.

Effect of real depreciation on equilibrium output has been shown. At equilibrium the country was running trade deficit earlier, however, post real depreciation it runs a trade surplus. The real depreciation moves the net demand upwards from ZZ+X-Q(IM) to ZZ+X-Q'(IM), while the domestic demand of goods remain the same as earlier. The equilibrium output is given by the intersection of line Y=Z with ZZ+X-Q'(IM), which as can be seen to have increased.

Increase in foreign demand has the same effect, however, depreciation increases the price of imports and therefore makes consumers worse off unlike in the case with the increase of foreign demand.

Effect of real depreciation and fiscal policy on equilibrium output has been shown. As observed in the case above, although the real appreciation leads to an improvement in the trade deficit, it also increased equilibrium output. If the case requires equilibrium output to remain unchanged alongside requires improvement in trade balance then a combination of policies can be used i.e. real depreciation alongside fiscal policies as shown here. Real depreciation was followed by fiscal contraction. Real depreciation shifts the ZZ+X-Q(IM) upwards to ZZ+X-Q'(IM). However, fiscal contraction brings it back to the original ZZ+X-Q(IM). Also, fiscal contraction reduces domestic demand of goods bringing ZZ down to ZZ' such that older equilibrium output is maintained in the open economy, and now with improved trade balance.

Although it looks as if real depreciation is beneficial, however, in reality, the adjustment process takes time. Post real depreciation the 3rd factor (Q(IM)) dominates and immediate effect of prices are observed, which deteriorates the trade balance. Over time, exports (X) and imports (IM) adjust to improve the overall trade balance. These dynamics are called the J-curve effect.