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In this article we will discuss about the Mundell model with its criticisms.
Mundell discusses the case of relationship between two tools and two objectives. The two instruments are monetary policy represented by interest rate and fiscal policy represented by government expenditure. The two objectives are full employment (internal balance) and balance of payments equilibrium (external balance).
The assignment rule is to assign monetary policy to the objective of external balance and fiscal policy to internal balance. The assignment of these instruments to the objectives is illustrated in Fig. 3. In the figure, the horizontal axis measures interest rate (monetary policy) and the vertical axis budget surplus (fiscal policy). FF is the internal balance line and XX the external balance line. The FF line represents full employment. It is negatively sloped because a reduction in budget surplus must be balanced by an increase in interest rate in order to maintain full employment.
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There is inflation below this line FF (zone III and IV), and recession above it (zone I and II). On the other hand, line XX gives all points of equilibrium in the balance of payments. It is also negatively sloped because a reduction in the budget surplus increases imports which must be counteracted by an improvement on capital account through an increase in interest rate. There is deficit in the balance of payments below this line (zone I and IV), and surplus above this line (zone II and III).
The XX line is steeper than the FF line because an increase in interest rate in order to balance an expansionary fiscal policy (increase in budget deficit or reduction in budget surplus) induces a short-term capital inflow for an external balance. The more responsive capital movements are to interest rate changes, the steeper is the XX line relative to the FF line. This makes monetary policy relatively more effective for maintaining external balance.
Fig. 3 illustrates external and internal balance and the role played by monetary and fiscal policy in maintaining equilibrium between the two. Suppose the economy is at point A in zone I where there is full employment within the economy and deficit in the balance of payments. To remove balance of payments deficit, the monetary authority acts first by increasing the interest rate by AB in order to reduce the money supply.
The reduction in money supply will reduce demand for goods and this will, in turn, decrease imports, and restore equilibrium in the balance of payments at B. But here the economy is having recession and unemployment.
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To correct these and to have internal balance, budget surplus will have to be reduced by BC. But at C, there is again deficit in the balance of payments which necessitates further increase in interest rate by CD for reducing the money supply.
At D the internal balance is again disturbed leading to a further reduction in budget surplus. This process of reduction in money supply followed by reduction in budget surplus will ultimately lead the economy to the equilibrium point E where there is simultaneous internal and external balance.
On the other hand, if budget surplus is used to remedy the deficit in balance of payments and monetary policy to correct recession and unemployment, there would be neither external balance nor internal balance. Starting from point A an increase in budget surplus would move the economy to K where the external balance is achieved but there is recession and unemployment in the economy. To remedy it, the interest rate is reduced by KL for increasing the money supply. But at L the deficit in the balance of payments rises over its previous level.
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This will require a still greater budget surplus by LM. This will necessitate still larger reduction in interest rate to remove recession and unemployment. In this way, the economy would move further and further away from point E and there would not be simultaneous internal and external balance. In this case, the assignment rule leads to explosive instability because the two policies are badly coordinated.
Thus monetary policy should be assigned to the objective of external balance and fiscal policy to that of internal balance. However, the assignment rule can work only if monetary and fiscal policy can be adjusted smoothly and continuously without long lags before their effects are visible. This is Mundell’s principle of effective use of monetary and fiscal policy for internal and external stability, according to which an instrument should be matched with the target on which it exerts the greatest relative influence. He calls it the Principle of Effective Market Classification.
In fact, Mundell argues for a judicious monetary and fiscal-policy mix. In zones II and IV, there is no inconsistency in jointly using both monetary and fiscal policies. In Zone II both policies should be restrictive, and in Zone IV both policies should be expansionary.
In the remaining two zones monetary and fiscal policies must be mixed in order to realise both objectives simultaneously. Both objectives will be realised, according to Mundell, when monetary policy is paired with the objective of external balance and fiscal policy with the objective of internal balance.
Criticisms of Mundell’s Model:
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There are, however, several shortcomings of this analysis. First, this model assumes that the authorities know the extent to which the economy is away from both internal and external balance so that appropriate monetary and fiscal policy can be applied.
It also presupposes that they know the quantitative results which are expected from the application of each policy. Both these assumptions are away from reality because it is not possible to estimate the degree of disequilibrium correctly.
Accordingly, the policy changes may not be appropriate to the type of disequilibrium. Second, this analysis overlooks the situation of unemployment and inflation. This is unrealistic because this phenomenon, known as stagflation, is found in almost all developed countries.
Third, this analysis considers only differences in interest rates as the cause of capital movements and neglects other factors such as exchange rate variations. Moreover, it is not possible that a persistent deficit may be financed by means of capital movements.
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Fourth, monetary and fiscal policies operate under certain practical constraints. Due to political reasons, some governments are unable to follow a restrictive fiscal policy and a monetary policy of high interest rates. Even if such policies can be started, they may not be successful because capital flows may not be interest-sensitive.
Fifth, the prescribed policy mix may be unable to correct a current account deficit. Since the policy mix affects both the capital flows and imports, it can only ensure that a negative trade balance is offset by a positive capital flow, and vice versa.
Sixth, the monetary-fiscal mix is not a true adjustment mechanism. It is just a palliative. It does not adjust the balance of payments but simply stabilises it. Capital flows only fill the gap between autonomous demand and supply of foreign exchange, leaving prices and incomes unchanged.
Seventh, this analysis does not take into account the debt-servicing requirements that a continuous capital inflow would have on the current account of the balance of payments when the domestic interest rate is raised.
Eighth, when the interest rate is raised through monetary policy, it will lead to a decrease in investment at home. This must be accompanied either by increase in government expenditure or by tax reductions or by a combination of both. Such a monetary-fiscal mix wastes the economy’s savings by diverting them into debts financed government expenditure which retards capital formation. According to Johnson, this raises the problem of “inefficiency versus efficiency in the use of domestic saving potential.”
Ninth, there is the possibility of conflicts between the prescribed policy mixes among governments of different .countries. As pointed out by Johnson, “Arriving at the right combination of fiscal and monetary policies in all countries simultaneously, especially if the adjustment of policies takes place by sequential trial and error, will be a complicated process and may in some circumstances lead away from rather than towards equilibrium.”
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