Module 11.3 LOS 11.k: Mundell-Fleming Model, Pure Monetary Model, Dornbusch Overshooting Model, Portfolio Balance Approach

Monetary and fiscal policies can have effects on exchange rates. The CFA curriculum covers a few theories on the mechanisms that lead to these changes.

Mundell-Fleming Model

Model assumes no inflation concerns and the ability of an economy to handle changes in aggregate demand. The implication of monetary policy vary in this model based on the exchange rate regime of the country in question.

Monetary and Fiscal Policy and Exchange Rates

Monetary Policy/Fiscal Policy Capital Mobility
Flexible Rate Regimes High Low
Expansionary/Expansionary Uncertain Depreciation
Expansionary/Restrictive Depreciation Uncertain
Restrictive/Expansionary Appreciation Uncertain
Restrictive/Restrictive Uncertain Appreciation

Under Mundell-Fleming, in a Fixed Exchange Rate Regime, where a countries currency is tied to the value of another, a government cannot pursue independent monetary policy while managing it’s exchange rates. The idea is that any monetary actions would lead to an offsetting move in the exchange rate to keep the currency fixed, and vice versa.

Monetary Approach to Exchange Rate Determination

Under monetary models, inflation is the mechanism that drives exchanges rate changes coming from monetary policy.

The pure monetary model assumes that PPP holds and output is constant. Expansionary monetary policy leads to an increase in process and a decrease in the value of the domestic currency. Therefore an x% increase in the money supply leads to an x% increase in price levels and then to an x% depreciation of domestic currency. The pure monetary approach does not take into account expectations about future monetary expansion or contraction.

The Dornbusch overshooting model is similar to a pure monetary model, but includes sticky short term prices. Prices do not immediately reflect changes in monetary policy but exchange rates will overshoot the long-run PPP value in the short term. In the case of an expansionary monetary policy, prices increase, but over time. Expansionary monetary policy leads to a decrease in interest rates—and a larger-than-PPP-implied depreciation of the domestic currency due to capital outflows. In the long term, exchange rates gradually increase toward their PPP implied values.

Portfolio Balance Approach to Exchange Rate Determination

The Portfolio Balance Approach focuses on the effects of fiscal policy in the long term, specifically addressing the effects of a sustained fiscal surplus or deficit on currency values.

Essentially, running fiscal deficits puts pressure on a government to deliver high enough risk premiums to continue attracting investors to lend the government money. However, these deficits can become unsustainable and eventually to lead to currency depreciation as investors pull out capital and stop new investments into the country.

Combining the Mundell-Fleming and portfolio balance approaches, we find that in the short term, with free capital flows, an expansionary fiscal policy leads to domestic currency appreciation (via high interest rates). In the long term, the government has to reverse course (through tighter fiscal policy) leading to depreciation of the domestic currency. If the government does not reverse course, it will have to monetize its debt (i.e., print money—monetary expansion), which would also lead to depreciation of the domestic currency.

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