Open Economy Monetary Policy Reconsidered

Abstract

The standard policy rule of the Mundell-Fleming model states that under a flexible exchange rate regime with perfectly elastic capital flows, monetary policy is effective and fiscal policy is not. The rule ignores the effect of a change in the nominal exchange rate on the domestic price level. The price level effect is noted in some textbooks, but not formally analyzed. When subjected to a rigorous analysis, the interaction of the exchange rate and the domestic price level substantially changes the standard policy rule. The logically correct statement would be, with a flexible exchange rate and perfectly elastic capital flows, the effectiveness of monetary policy depends on the marginal import propensity and the sum of the trade elasticities. Typical values for these parameters suggest that the effectiveness of monetary policy under flexible exchange rates can be low even if capital flows are perfectly elastic. Because these same parameters have the opposite effect on fiscal policy, the relative effectiveness of fiscal and monetary interventions under a flexible exchange rate is an empirical issue that cannot be determined a priori.

Acknowledgments

The author thanks Alfredo Calcagno of UNCTAD, Philip Arestis of Cambridge University, Robert Pollin of the University of Massachusetts (Amherst), Alemayehu Geda of Addis Ababa University, Alex Izurieta of the United Nations Department of Economic and Social Affairs, Anwar Shaikh and Duncan Foley of the New School University, Olav Lindstol of the Embassy of Norway in Zambia, Jan Toporowski and Alfredo Saad Filho of the School of Oriental and African Studies, and Sedat Aybar of Kadir Has University for their comments.

Notes

¹The evolution of the model is treated in detail in Darity & Young (2004). Representative of the full version of the model are Fleming (1962) and Mundell (1963).

²Dunn & Mutti (2004, p. 431) write that ‘There is now relatively little serious discussion of abandoning flexible [exchange] rates.’

³The Marshall-Lerner condition is more often stated for export and import revenue elasticities.

⁴The price level, P, is equal to the weighted average of domestic prices (P _d ) and import prices: P = (1 – a ₃)P _d  + a ₃ E. When domestic prices are constant and product markets competitive, the rate of change of the price level is the marginal propensity to import out of income times the change in the exchange rate (see Agenor & Montiel, 1996, pp. 44–45).

⁵For developed countries, see Bahmani-Oskooee & Kara (2003) and Boyd et al. (2001). These studies show quite low short-term elasticities.

⁶To be consistent with the small-country assumption, this average excludes the United States, Japan, European Union, China and India. It also excludes city states and very small countries, the latter defined as those with populations less than one million. The statistics are from World Development Indicators 2010 [http://data.worldbank.org/data-catalog/world-development-indicators/wdi-2010].