Limitations of the Mundell-Fleming model
The IS-LM-BP model has been one of the major policy models underlying economic policy formulation for open economies in the last three decades.Given this, we need to look at some of the limitations of the model.A number of the criticisms relate to the short-run nature of the model.
The Marshall-Lerner condition—The model assumes that the Marshall-Lerner condition holds even though it is essentially of a short-term model which is the time scale under which the Marshall-Lerner conditions are least likely to be met.
Interaction of stocks and flow—The model ignores the problem of the interaction of stocks and flows.According to it a current account deficit can be financed by a capital inflow.While such a policy is feasible in the short run, a capital inflow over time increases the stock of foreign liabilities owed by the country to the rest of the world, and this factor means a worsening of the future current account as interest is paid abroad.Clearly, a country cannot go on financing a current account deficit indefinitely as the country becomes an ever-increasing debtor to the rest of the world.
Neglect of long-run constraints—In an excellent review of the Mundell-Fleming model, Frenkel and Razin (1987)highlight one of its major deficiencies in that it fails to take account of long-run constraints that govern both the private and public sector.In the long run private-sector spending has to equal its disposable income, while in the absence of money creation government expenditure (inclusive of its debt service repayments)has to equal its revenue from taxation.This means that in the long run the current account has to be in balance.One implication of these budget constraints is that a forward-looking private-sector would realize that increased government expenditure will imply higher taxation for them in the future, and this will induce increased private-sector savings today that will undermine the effectiveness of fiscal policy.
Wealth effects—The model does not allow for wealth effects that may help in the process of restoring long-run equilibrium.A decrease in wealth resulting from a fall in foreign assets associated with a current account deficit will ordinarily lead to a reduction in import expenditure which should help to reduce the current account deficit.While such an omission of wealth effects on the import expenditure function may be justified as being of small significance in the short run, the omission nevertheless again emphasizes the essentially short-term nature of the model.
Neglect of supply-side factors—One of the obvious limitations of the model is that it concentrates on the demand side of the economy and neglects the supply side.There is an implicit assumption that supply adjusts in accordance with changes in demand.In addition, because the aggregate supply curve is horizontal up to full employment, increases in aggregate demand do not lead to changes in the domestic price level, rather they are reflected solely by increase in real output.
Treatment of capital flows—One of the biggest problems of the model concerns the modeling of capital flows.It is assumed that a rise in the domestic interest rate leads to a continuous capital inflow from abroad.However, it is unrealistic to expect such flows to continue indefinitely because after a point international investors will have rearranged the stocks of their international portfolios to their desired content and once this happens the net capital inflows into the country will cease.The only way that the country could then continue to attract capital inflows would be a further rise in its interest rate until once again international portfolios are restored to their desired content.Hence, a country that needs a continuous capital inflow to finance its current account deficit has to continuously raise its interest rate.In other words, capital inflows are a function of the change in the interest differential rather than the differential itself.
Exchange-rate expectations—A major problem with the model is the treatment of exchange-rate expectations.The model does not explicitly model these and implicitly presumes that the expected change is zero, which is known as static exchange-rate expectation.While this might not seem to be an unreasonable assumption under fixed exchange rates, it is less tenable under floating exchange rates.According to the model a monetary expansion leads to a depreciation of the currency under floating exchange rates—in such circumstances it seems unreasonable to assume that economic agents do not expect depreciation as well.If agents expect depreciation this may require a rise in the domestic interest rate to encourage them to continue to hold the currency which will have an adverse effect on domestic investment—implying a weaker expansionary effect of monetary policy than is suggested by the model.Indeed, the need to maintain market confidence in exchange rates can severely restrict the ability of governments to pursue expansionary fiscal and monetary policies.
Flexibility of policy instruments—Another criticism is that the analysis is of a comparative static nature and assumes that adjusting monetary and fiscal policy is a fairly simple matter.In the real world the political process means that the degree of flexibility to adjust economic policy, especially fiscal policy, is hard to achieve.