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.

The global reach of the Fed, and why it is time to discard Mundell-Fleming

Miranda-Agrippino and Rey have an important new paper out on global transmission of money shocks.  I find the abstract poorly presented, but here are the key sentences from the body of the paper:

…US monetary policy has a significant effect on the leverage of US and European investors (particularly continental European and UK banks who have large capital market operations and are classified as systemically important banks), on cross-border credit flows and on credit growth worldwide…Our results are not driven by the crisis period…

I am not sure if I should feel better or worse about all that, in the meantime beware of purely domestic monetary policy arguments for a particular policy.

Note also that the Mundell-Fleming model is looking rather weak these days.  Not long ago Olivier Blanchard and co-authors told us that capital inflows are expansionary, now there is more work from Cambridge telling us that floating exchange rates do not insulate a country from the monetary policy of its neighbors.

Isn’t it time to conclude that the Mundell-Fleming is mostly wrong?  You know wrong, as in…not correct.  Incorrect, in fact.

Fiscal multipliers at the zero bound in an open economy

Let’s continue our look at debates over UK fiscal adjustment.

Will fiscal policy work in an open economy? The standard view has
been that in a Mundell-Fleming model fiscal expansion appreciates
the exchange rate and hurts the trade balance, thus offsetting
the fiscal policy. The U.S. may be too closed an economy for this
to be a big deal, but for the UK it seems this might apply, at
least if one is operating within Keynesian frameworks.

The recent Keynesian response has cited the “lower bound” as a
reason why fiscal policy still may be effective in an open
economy. But what does this literature really show? Let’s take a
brief tour of it, starting with the August 2012 piece by Emmanuel Farhi and Ivan Werning,
brilliant Harvard and MIT guys. Their piece is clear and
excellent, and it shows what the case for fiscal policy in this
setting looks like. (I don’t read them as offering concrete
advice to current governments and thus I have no criticism of
their paper, which I am pleased to have spent time with.)

Here are a few points:

1. “…the effects of government consumption work through
inflation.” In other words, if you think the BOE has greater
influence over inflation than UK government spending, you do not
need the other results of this paper for macro policy. I get the
point of “the central bank cannot precommit to elaborate
targeting schemes over time,” but that’s not what we need here.
We just need some basic money-induced price inflation to render
monetary policy dominant over fiscal policy, even in this case.
And pretty much everyone thinks the BOE can influence the rate of
price inflation. The rates of price inflation we are getting are
not some kind of strange coincidence.

By the way, even with a so-called liquidity trap, the BOE also
can play QE with the exchange rate, as do the Swiss.

2. The zero bound open economy model predicts that fiscal
tightening leads to exchange rate appreciation (contra the usual
Mundell-Fleming case), yet here is the British pound against the

Not an obvious fit to the prediction. There are countervailing
factors, to be sure, but maybe that’s the broader story too.

3. The model in the paper suggests that “current” fiscal policy
won’t much help aggregate demand. Fiscal policy does best the
further away in time it is
, provided it does not happen
after the liquidity trap goes away. This makes sense if you view
inflation as the channel for the effectiveness of fiscal policy.
Getting the inflation over with won’t help much, but if it hangs
over people’s heads they will spend more in response. In fact
there is even a problem that the multiplier can be infinite if
fiscal policy is sufficiently well-time and back-loaded.

None of this corresponds with the advice we actually are hearing.

4. The greater the nominal stickiness of prices in the model, the
weaker the Keynesian effects and in the limiting case they
approach zero. Yet we are told (by the policy commentators) that
nominal stickiness is of the utmost importance.

Let’s consider a few other pieces and points:

5. It is common for these papers to rely on squirrely mechanisms
of intertemporal substitution, which in other contexts are mocked
by Keynesians. Consider
Fujiwara and Ueda
, a commonly cited paper on fiscal
multipliers and the zero bound:

Incomplete stabilization of marginal costs due to the existence
of the zero lower bound is a crucial factor in understanding
the effects of fiscal policy in open economies. Thanks to
this, government spending in the home country raises the
marginal costs of home-produced goods, which increases expected
inflation rates and decreases real interest rates.
Intertemporal optimization causes consumption to increase, so
that the fiscal multiplier exceeds one. While government
spending continues, the price of home-produced goods increases
more than that of foreign-produced goods. Expecting that two
countries are at symmetric equilibrium when government spending
ends, the home currency depreciates and the home terms of trade
worsen on impact when government spending begins. That shifts
demand for goods from foreign-produced goods to home-produced
ones. The fiscal spillover thus may become negative depending
on the intertemporal elasticity of substitution in consumption.

If a passage like that came from an RBC theorist it would be
mocked, but in support of activist fiscal policy it passes
without critical comment.

6. When it comes to Japan and the Japanese lower bound, the
empirical evidence seems to show that “standard theory” predicts
quite well and the stranger zero bound theories do not predict
well. Here is Braun and

We show that a prototypical New Keynesian model fit to Japanese
data exhibits orthodox dynamics during Japan’s episode with
zero interest rates. We then demonstrate that this
specification is more consistent with outcomes in Japan than
alternative specifications that have unorthodox properties….

Those same zero bound Keynesian models predict that economies
should have quite volatile responses to real shocks, yet they do

We also considered specifications of the model that have larger
government purchase multipliers and some which also exhibit
unorthodox predictions for the response of output to labor tax
and technology shocks. We found that these specifications are
difficult to square with the fact that the period of zero
interest rates in Japan between 1999 and 2006 was a period of
low economic volatility. All of the specifications predict the
opposite should have occurred. The specifications with
unorthodox properties also have other problems. They predict
large resource costs of price adjustment which are difficult to
reconcile with empirical evidence that menu costs are small and
they require that households expect the period of zero interest
rates to be counterfactually long.

Need I state the irony that proponents of the relevance of the
zero bound often insist that real shocks simply aren’t making
such a big difference in recent years? That is inconsistent with
the basic model which they otherwise are citing.

7. In these settings (and assuming away all the problems above),
a lot of the effectiveness of fiscal policy, or sometimes all of
it, comes from “beggar thy neighbor” effects. Read Cook
and Devereux
for some illustrative cases. Beggar thy neighbor
strategies are criticized and rejected when Germany (supposedly)
does them through its export prowess, but in the context of
fiscal policy they seem to be given a free pass.

8. In fact I could make further points but I believe that is

The bottom line: A look at this new and
interesting literature shows it does not support the
interpretations which the “policy commentariat” Keynesians are
putting on it and in some regards it even opposes those
interpretations. When it comes to UK fiscal policy, we are seeing
again what I described
last week
: exaggeration and a lack of transparency in

A simple parable of price stickiness and international externalities

Olivier Blanchard and Nobuhiro Kiyotaki published a famous "Keynesian" paper in 1987 and it remains a well-cited piece in macroeconomics.  One central result is that prices and wages can get stuck too high, above market-clearing.  Market participants who produce more and lower prices and wages confer a strong large and positive externality on other individuals (or regions) in the market.  Of course in the absence of such adjustments, activist monetary policy is recommended, but the point about externalities remains.

Yet often, today, we are told that the individuals (or regions) which produce (i.e., export) more are imposing negative externalities on other individuals or regions.

Of course the Blanchard and Kiyotaki model had its limitations.  It did not, for instance, incorporate open economy considerations.  It could be that the star producers impose an unfavorably high exchange rate on the broader region and hurt the ability of the broader region to export to the larger world economy.

When the open economy considerations are relatively strong, that coincides with…the conditions under which a coordinated fiscal policy will prove counterproductive, for reasons shown by the Mundell-Fleming model.  In other words, if you think the strong Eurozone countries are hurting the Eurozone weakies, you also should be skeptical about coordinated European fiscal policy.  This paper surveys some key issues.

In many open economy versions of the B-K model, or variants, looser monetary policy simply exports the problems of the region to other parts of the world.  So why advocate such policies, especially if you are an outsider?  Maybe the EU determines its own economic destiny (fine by me) but then we're back to German production and prosperity helping Spain rather than hurting it, for the reasons given by B-K.

In this well-regarded model, the international spillover effects from the monetary expansion can be either positive or negative.  But it takes work to get those effects into the positive category.

Here is a survey of some literature which extends the sticky price model to open economy and policy coordination settings.

It is commonly suggested that German exports damage (or help) Spain without considering the broader implications of that proposition.

Overall, the results may depend on whether wage rigidity is real or nominal in each currency, the degree of capital mobility, the currency of invoicing in which sticky prices are set, and how much market participants look forward and consider stocks in addition to flows.  This paper surveys some issues.  There are many permutations, to the point where they are perhaps no longer very useful.

I wish to emphasize the broader point that not all combinations of views here are mutually consistent.

My Ph.d. Macro reading list

Books: J. Bradford DeLong: Intermediate Macroeconomics, and Paul Blustein, And the Money Kept Rolling in (and Out)

Real Business Cycles

Stadler, George. “Real Business Cycles,” Journal of Economic Literature, December 1994, 1750-1783.

Long, John B. and Plosser, Charles. “Real Business Cycles,” Journal of Political Economy, 1983, 39-69.

Barsky, Robert and Miron, Jeffrey. “The Seasonal Cycle and the Business Cycle,” Journal of Political Economy, 1989, 503-534.

Prescott-Summers debate, Quarterly Review, Minneapolis Fed., “Theory Ahead of Business Cycle Measurement,” “Some Skeptical Observations on Real Business Cycle Theory,” and “Response to a Skeptic.”

Bils, Mark. “The Cyclical Behavior of Marginal Cost and Price,” American Economic Review, 1987, 838-55.

Romer, Christina. “Changes in Business Cycles,” Journal of Economic Perspectives, Spring 1999, 23-45.

Black, Fischer. “Noise,” Journal of Finance, 1986.

Mehrling, Perry. “Understanding Fischer Black,” you can find this paper at:

Finance and interest rates

Ross, Stephen. “Finance,” In The New Palgrave, pp.322-336.

Chapters six and seven, “Objects of Choice,” and “Market Equilibrium”.

Jagannathan, Ravi  and McGrattan, Ellen. “The CAPM Debate.” Federal Reserve Bank of Minneapolis,  Fall 1995, 2-17.

Campbell,  John Y. and Vuolteenaho, Tuomo, “Bad Beta, Good Beta,” American Economic Review, December 2004, 1249-1275.

Campbell, John, “Some Lessons for the Yield Curve,” Journal of Economic Perspectives, Summer 1995, 129-152.

Siegel, Jeremy and Thaler, Richard. “The Equity Premium Puzzle,” Journal of Economic Perspectives, Winter 1997, 191-200.

Kocherlakota, Narayana R. “The Equity Premium: It’s Still a Puzzle,” Journal of Economic Literature, March 1996, 42-71.

Lee, Charles, Shleifer, Andrei, and Thaler, Richard. “Anomalies: Closed End Mutual Funds,” Journal of Economic Perspectives, Fall 1990, 153-164.

Keynesian Economics

Cowen, Tyler. “Why Keynesianism Triumphed Or, Could So Many Keynesians Have Been Wrong?”, Critical Review, Summer/Fall 1989, 518-530.

“Symposium: Keynesian Economics Today,” Journal of Economic Perspectives, Winter 1993, 3-82.

“Is There a Core of Practical Macroeconomics That We Should All Believe?” American Economic Review, symposium, May 1997, 230-246.

Taylor, John. “Reassessing Discretionary Fiscal Policy,” Journal of Economic Perspectives, Summer 2000, 21-36.

Bernheim, B. Douglas. “A Neoclassical Perspective on Budget Deficits,” Journal of Economic Perspectives, Spring 1989, 55-72.

Eisner, Robert. “Budget Deficits: Rhetoric and Reality,” Journal of Economic Perspectives, Spring 1989.

Stiglitz, Joseph E. “The Causes and Consequences of the Dependence of Quality on Price.” Journal of Economic Literature, March 1987, 1-48.

Hall, Robert E. “Employment Fluctuations with Equilibrium Wage Stickiness,” American Economic Review, March 2005, 50-65.

Summers, Lawrence. “The Scientific Illusion in Empirical Macroeconomics,” Scandinavian Journal of Economics, 1991, 129-148.

Monetary Policy

Blinder, Alan. “What Central Bankers Can Learn From Academics – and Vice Versa,” Journal of Economic Perspectives, Spring 1997, 3-20.

Bernanke, Ben and Mishkin, F. “Inflation Targeting,” Journal of Economic Perspectives, Spring 1997, 97-117.

Aiyagari, S. Rao, “Deflating the Case for Zero Inflation,” Federal Reserve Bank of Minneapolis, Quarterly Review, Summer 1990, 2-11.

“Symposium on the Monetary Transmission Mechanism,” Journal of Economic Perspectives, Fall 1995, 3-96.

Roberds, William. “What Hath the Fed Wrought? Interest Rate Smoothing in Theory and Practice,” Federal Reserve Bank of Atlanta, Economic Review, January/February 1992.

Shafir, Eldar, Diamond, Peter, and Tversky, Amos. “Money Illusion,” Quarterly Journal of Economics, May 1997, 341-374.

Caplin, Andrew and Spulber, Daniel. “Menu Costs and the Neutrality of Money,” Quarterly Journal of Economics, November 1987, 703-725.

Sargent, Thomas and Wallace, Neil. “Some Unpleasant Monetarist Arithmetic,” Federal Reserve Bank of Minneapolis, Quarterly Review, 1985, 1-17.

Wallace, Neil. “A Legal Restrictions Theory of the Demand for “Money” and the Role of Monetary Policy,” Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1983.

Posen, Adam. “Why Central Bank

Independence Does Not Cause Low Inflation: There is No Institutional Fix for Politics,” in Finance and the International Economy, edited by Richard O’Brien, 1993.

Garrison, Roger, “The Austrian Theory of the Business Cycle,” At  href=""

Krugman, Paul. “The Hangover Theory,” at

Cowen, Tyler. Risk and Business Cycles, chapter three.

Savings and social security

Hubbard, R. Glenn and Skinner, Jonathan. “Assessing the Effectiveness of Savings Incentives.” Journal of Economic Perspectives, Fall 1996, 73-90.

Choi, Laibson, Madrian, and Metrick, “Optimal Defaults,” American Economic Review, May 2003, also at ttp://

Samwick, Andrew. Voxbaby weblog, read the entries on social security.

International Economics

Current issues:

“If I Believed in Austrian Business Cycle Theory,” by

Tyler  Cowen, on

Brad Setser’s WebLog.

Dornbusch, Rudiger. “Purchasing Power Parity,” in The New Palgrave.

Friedman, Milton. “The Case for Flexible Exchange Rates.” In Essays in Positive Economics, 1953, University Chicago Press.

Mundell-Fleming model, see Brad’s book.

The World


Krugman, Paul R. “It’s Baaack:

Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity, 1998, 29, 2, 137-87.

Kashyap, Anil K. “Sorting out Japan’s Financial Crisis,” Federal Reserve Bank of Chicago Economic Perspectives, 2002, 26, 4, 42-55.





Developing Nations



Bordo, Michael D. “Essays in Exploration: A Survey of the Literature,” Explorations in Economic History, 1986, 339-415.

“Symposium: The Great Depression,” Journal of Economic Perspectives, Spring 1993, 3-102.

Romer, Christina H “What Ended the Great Depression?” Journal of Economic History, 1992, 52, 4, 757-84.

Here is a searchable link to Brad DeLong’s website: