Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates

Mundell assumes “the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad,” stating plainly that “this assumption will overstate the case but it has the merit of posing a stereotype towards which international financial relations seem to be heading” (p. 475). He argues it is not far from descriptive reality in financial centres such as Zurich, Amsterdam, and Brussels, and has “a high degree of relevance to a country like Canada whose financial markets are dominated to a great degree by the vast New York market” (p. 475) – grounding an admittedly polar theoretical case in a specific, plausible real-world referent.

Mundell assumes unemployed resources, constant returns to scale, and fixed money wages (so domestic output supply is elastic and the price level constant), that saving and taxes rise with income, that the trade balance depends on income and the exchange rate, that investment depends on the interest rate, that money demand depends on income and the interest rate, and that the country is too small to affect foreign income or the world interest rate (p. 476). Monetary policy is defined specifically as open-market purchases of securities, fiscal policy as increased government spending financed by public debt issuance; “floating exchange rates result when the monetary authorities do not intervene in the exchange market, and fixed exchange rates when they intervene to buy and sell international reserves at a fixed price” (p. 476).

Table I organizes the economy into government, private, and foreign sectors (rows, showing how each sector’s expenditure is financed – e.g., a government budget deficit financed by new debt or dishoarding) and four objects of exchange – goods, international reserves, money, and securities (columns, each a market that must clear) (pp. 476-477). Mundell notes that “if the entries are defined as ex ante or planned magnitudes both the horizontal and vertical sums to zero are equilibrium conditions, but if they are defined as ex post or realized magnitudes the sums to zero are identities” (p. 477) – this bookkeeping discipline is what lets him trace, step by step, exactly how a policy-induced imbalance in one market must show up as a compensating flow somewhere else.

An open-market purchase increases bank reserves and the money supply, puts downward pressure on the interest rate, and – because that fall is prevented from persisting by an instantaneous capital outflow – causes the currency to depreciate; the ensuing improvement in the trade balance raises income and employment through the multiplier until income has risen enough that the community willingly holds the enlarged money stock (pp. 477-478). Because the interest rate ends up unaltered, income must rise “in proportion to the increase in the money supply, the factor of proportionality being the given ratio of income and money” – a quantity-theory result. Mundell stresses that “monetary policy therefore has a strong effect on the level of income and employment, not because it alters the rate of interest, but because it induces a capital outflow, depreciates the exchange rate, and causes an export surplus” (p. 478).

Yes – Mundell shows that central bank purchases of foreign reserves with domestic money are, under flexible rates, “virtually the same” as the conclusion reached for domestic open-market operations, expanding bank reserves and the money supply, depreciating the currency, and raising income and employment through an export surplus, with the only difference being that foreign rather than domestic assets of the banking system increase (p. 478). This establishes “open market operations” in foreign exchange as an equally forceful alternative tool of stabilization policy under flexible rates.

An increase in government spending initially creates excess demand for goods and tends to raise income, but the resulting higher money demand raises interest rates, attracts a capital inflow, and appreciates the exchange rate – and this currency appreciation’s depressing effect on income “has to offset exactly the positive multiplier effect on income of the original increase in government spending” (p. 479). Since income cannot change unless the money supply or the (fixed, world-determined) interest rate changes, and neither does, “fiscal policy thus completely loses its force as a domestic stabilizer when the exchange rate is allowed to fluctuate and the money supply is held constant” (p. 479); the entire effect of the fiscal expansion instead shows up as an equal-sized import surplus financed by an equal capital inflow.

An open-market purchase again puts downward pressure on interest rates, again prevented by capital outflow, but now this worsens the balance of payments, forcing the central bank to sell foreign exchange to defend the peg – a process that continues “until the accumulated foreign exchange deficit is equal to the open market purchase and the money supply is restored to its original level” (p. 479). Mundell describes this succinctly: the central bank has merely “traded domestic assets for foreign assets,” with the only lasting effect being an equivalent fall in reserves and no change in income.

Under a pegged rate, a debt-financed government spending increase raises income through the ordinary Keynesian multiplier, and the resulting rise in money demand pushes interest rates up and attracts a capital inflow that forces the central bank to buy reserves and passively expand the money supply – “the money supply is therefore increased indirectly through the back door of exchange rate policy” (pp. 479-480). In the new equilibrium, capital-market balance requires that the import deficit induced by higher income be exactly matched by the capital inflow, so that balance-of-payments equilibrium is restored even as income and reserves have both permanently risen.

When the central bank directly buys the government securities issued to finance a budget deficit, Mundell derives the striking result that, in the new equilibrium, “reserves fall at a rate equal to the budget deficit” – the entire deficit is financed at the expense of reserves, once an initial one-time stock-adjustment inflow (from the increased transactions demand for money) has been netted out (pp. 480-481).

Sterilization requires the central bank to buy or sell securities at exactly the same rate that it is buying or selling foreign exchange, so as to keep the domestic money supply from changing when it intervenes to hold the exchange rate fixed. Mundell shows that if government spending rises while sterilization is attempted, “the system has now become inconsistent, for goods market equilibrium requires an increase in income, but an increase in income can only take place if either the money supply expands or interest rates rise” – and sterilization is specifically designed to prevent both (pp. 481-482). Attempting an open-market purchase under sterilization is even worse: it triggers a capital outflow and reserve loss, which the central bank tries to offset with further purchases, which trigger further outflows, in a self-reinforcing process with no stopping point short of exhausted reserves – “this is running water into a sink that is filled to the brim, causing the water to spill over the edges at the same rate that it is coming out of the tap. But sterilization operations are analogous to trying to prevent the water from spilling out, even though the sink is full and water is still pouring out of the tap” (p. 483).

For a given exchange rate, XX traces interest rate-income combinations clearing the goods market, LL traces those clearing the money market, and FF traces the external-balance condition pinned down by the world interest rate; a second pair of XX and FF schedules in the lower quadrant relates income to the exchange rate itself (p. 482). Under flexible rates, a monetary expansion shifts LL and (via the resulting depreciation and improved trade balance) also shifts XX and FF, arriving at a new equilibrium with higher income; under fixed rates, the same monetary shock leaves XX and FF unchanged, so the shifted LL curve must snap back to its original position as reserves adjust, restoring the original equilibrium Q (pp. 482-483). Fiscal expansion is shown to shift XX in both diagrams, appreciating the currency (and leaving income unchanged) under flexible rates, but raising both income and reserves under fixed rates (p. 483).

Several. Allowing money demand to depend on the exchange rate as well as income and interest rates “would slightly reduce the effectiveness of a given change in the quantity of money, and slightly increase the effectiveness of fiscal policy… under flexible exchange rates,” though it changes nothing under fixed rates; a real-balance effect and an exchange-rate effect on saving are both shown not to alter the qualitative results (p. 484). The analysis abstracts from growth (“my conclusions are, so to speak, superimposed on the growth situation”) and from disequilibrium dynamics. Mundell is explicit that his results depend on redefining “monetary policy” away from an interest-rate target (impossible under perfect capital mobility, since the authorities cannot move the market rate) and instead as an open-market operation, contrasting this with his own earlier (1961) paper’s different definitions and conclusions (p. 483, n. 5). Applying the analysis to Canada, he cautions that “the assumption of perfect capital mobility is not literally valid; my conclusions are black and white rather than dark and light grey,” and that to the extent Canada can sustain an interest-rate gap from the United States without triggering strong capital flows, fiscal policy retains some role under flexible rates and monetary policy some role under fixed rates – “but if this possibility exists for us today, we can conjecture that it will exist to a lesser extent in the future” (p. 485).