Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates

This 1963 Canadian Journal of Economics and Political Science paper by Robert Mundell asks what happens to monetary and fiscal policy’s power over domestic income and employment once capital is perfectly mobile internationally, so that a country cannot maintain an interest rate different from the world level. Working with a small open economy that has unemployed resources, fixed money wages, and a central bank that can either float the exchange rate or peg it by trading reserves, Mundell shows that the two policy instruments swap roles depending on the exchange rate regime: under flexible rates, an open-market money expansion depreciates the currency and raises income and employment by the full quantity-theory amount, while a debt-financed increase in government spending is entirely crowded out by capital inflows and currency appreciation, leaving income unchanged; under fixed rates, the opposite holds, with monetary policy powerless to sustainably change income (any attempted expansion leaks straight back out through reserve losses) while fiscal expansion works through the conventional Keynesian multiplier, financed by an induced reserve inflow. Mundell further shows that central-bank “sterilization” – trying to fix the exchange rate while also insulating the domestic money supply from the resulting reserve flows – is not merely difficult but strictly inconsistent under perfect capital mobility, since it demands two things (a fixed interest rate and a fixed money supply) that cannot both hold at once, producing an accelerating, non-convergent process rather than a new equilibrium. The paper’s headline conclusion is a stark policy-effectiveness reversal: classical (quantity-theory) conclusions govern monetary policy under floating rates, while simple Keynesian conclusions govern fiscal policy under fixed rates, with each instrument correspondingly neutered under the other regime.

R. A. Mundell | Macro Paper Warehouse

Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates