Further reasons why the Mundell-Fleming model is simply, flat-out wrong

Most trade is invoiced in very few currencies. Despite this, the Mundell-Fleming benchmark and its variants focus on pricing in the producer’s currency or in local currency. We model instead a ‘dominant currency paradigm’ for small open economies characterized by three features: pricing in a dominant currency; pricing complementarities, and imported input use in production. Under this paradigm: (a) terms of trade are stable; (b) dominant currency exchange rate pass-through into export and import prices is high regardless of destination or origin of goods; (c) exchange rate pass-through of non-dominant currencies is small; (d) expenditure switching occurs mostly via imports and export expansions following depreciations are weak. Using merged firm level and customs data from Colombia we document strong support for the dominant currency paradigm and reject the alternatives of producer currency and local currency pricing.

That is from a new NBER working paper by Casas, Díez, Gopinath, and Gourinchas.  Here are my previous posts on Mundell-Fleming.


Corollary: since Mundell-Fleming depends on money non-neturality (as does IS-LM) then this study is further evidence that money is indeed neutral, pace what monetarists like Scott Sumner say... -RL

Wikipedia: "The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output). The Mundell–Fleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," "irreconcilable trinity," "inconsistent trinity" or the "Mundell–Fleming trilemma."

Wikipedia: "Basic assumptions of the model are as follows:

Spot and forward exchange rates are identical, and the existing exchange rates are expected to persist indefinitely.
Fixed money wage rate, unemployed resources and constant returns to scale are assumed. Thus domestic price level is kept constant, and the supply of domestic output is elastic.
Taxes and saving increase with income.
The balance of trade depends only on income and the exchange rate.
Capital mobility is perfect and all securities are perfect substitutes. Only risk neutral investors are in the system. The demand for money therefore depends only on income and the interest rate, and investment depends on the interest rate.
The country under consideration is so small that the country can not affect foreign incomes or the world level of interest rates."

But the assumptions of the model does not address the issue of money neutrality. At least one textbook has said that the failure of any real effects to follow from volatile changes in nominal prices in Fx markets refutes the theory of money non-neutrality.

"HILLEL THE ELDER, a first-century religious leader, was asked to summarise the Torah while standing on one leg. “That which is hateful to you, do not do to your fellow. That is the whole Torah; the rest is commentary,” he replied. Michael Klein, of Tufts University, has written that the insights of international macroeconomics (the study of trade, the balance-of-payments, exchange rates and so on) might be similarly distilled: “Governments face the policy trilemma; the rest is commentary.” http://www.economist.com/news/economics-brief/21705672-fixed-exchange-rate-monetary-autonomy-and-free-flow-capital-are-incompatible

Come on, models are not right or wrong, they are useful or not useful for a given time and place.

An old colleague of mine: "Models are theories you don't really believe in."

Yes, the bulk of trade is invoiced in a few currencies.

But the exporters still have to translate the value received back to their local currency to determine if the trade is profitable.

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