Modern Economy, 2013, 4, 596-599
http://dx.doi.org/10.4236/me.2013.49064 Published Online September 2013 (http://www.scirp.org/journal/me)
Emerging Asia’s Version of the Mundell-Fleming Model
Suresh Ramanathan*, Kian Teng
Economics Department, Faculty of Economics and Administration, University Malaya, Kuala Lumpur, Malaysia
Received July 17, 2013; revised August 7, 2013; accepted August 13, 2013
Copyright © 2013 Suresh Ramanathan, Kian Teng. This is an open access article distributed under the Creative Commons Attribu-
tion License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly
cited.
ABSTRACT
This paper explains the Mundell-Fleming model in the context of Emerging Asia economies management of capital
mobility. Central Banks and Financial Regulators in Emerging Asia adopt a modified version of the model that incor-
porates two vital levers, a policy driven and a market driven method that is adaptable to the magnitude of capital flow.
A policy combination mix of both policy and market driven provides smooth monetary policy signal transmission to
exchange rates.
Keywords: Mundell-Fleming Model; Capital Mobility; Foreign Exchange Markets; Monetary Policy; Emerging Asia
1. Introduction
Stable exchange rates, independent monetary policy and
free capital flow, the trilemma or impossible trinity, sug-
gest that only two of the above three objectives can be
accomplished simultaneously according to Fleming and
Mundell (1962 and 1963) [1,2]. In assessing the trilemma,
findings by Mankiw (2010) [3] indicate China managed
to achieve stable exchange rates and independent mone-
tary policy that was accompanied by capital controls. But
can the trilemma be considered as a guide for macroeco-
nomic policy framework? Obstfeld et al. (2005) [4] sug-
gest economies that are without a pegged exchange rate
and have barriers to capital mobility can retain sufficient
amount of monetary policy independence whereas
economies with pegged exchange rates and do not have
barriers to capital mobility would lose significant mone-
tary policy independence. In a case study by Yu Hsing
(2012) [5] on selected EA economies, findings in support
of trilemma were evident in Malaysia, Philippines and
Singapore, while there was no evidence of a trilemma
situation in Indonesia and Thailand. Different macro-
economic policy combinations prevailed in Malaysia,
Philippines and Singapore, rendering the ability to switch
to different policy combination over time in order to deal
with major economic events. In conceptualizing the
Mundell-Fleming model within the trilemma objective, it
is pertinent to take into account the risk premium element
in the form of barriers to capital mobility. In EA foreign
exchange markets, barriers to capital mobility play a sig-
nificant role in managing the overall macroeconomic
policy framework. There are two key aspects of the EA
version of the Mundell-Fleming model, the market and
policy-driven space.
2. The Model
The Mundell-Fleming model for EA incorporates mar-
ket-driven, D point and policy-driven. E point (see Fig-
ure 1).
In the context of the standard model, points A, B and C
remain, indicating the choice for central banks and finan-
cial regulators being limited to adhering only two points
of preference, where the distance between A to C being
exchange rate fixing, A to B as monetary policy inde-
pendence and B to C as free capital mobility. In EA a
strict proposition of the Mundell Fleming model is a
constrain for central banks and financial regulators fol-
lowing the lessons learnt during the 1997/98 Asian Fi-
nancial Crisis. Consistent with this objective, Aizenman
et al. (2011a) [6] finds that for developing economies,
maintaining exchange rate stability was a key priority up
to the period of 1990, and since 2000, developing
economies pursued managed exchange rate flexibility
and retained partial monetary policy independence. The
task of managing capital mobility is to keep it in line
within the macroeconomic policy framework of the do-
mestic economy, therefore, the introduction of points D
and E. The midpoint of D to E is a policy combination
mix where the degree of capital mobility between A to D
*Corresponding author.
O
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S. RAMANATHAN, K. TENG 597
Market driven space
&
Ful l capita l mobi li ty
D
Tight l y Fixe d exch ang e rate
C
D - B
Degre e of Monet ary P olicy in de penden c e
D – C
Degree of exchange rate fixin g
Free capital mobility
Freely Floating exchange rate
B
*
Policy driven space
E
A - B
Monetary Po lic y
indep en d en ce
A - C
Exchange rate
fixing
No capital
mobility
A
D – A
Degree of
capital
mobility
D – E
Policy
combination
mix
Figure 1. Emerging Asia Mundell-Fleming model.
is adjusted using the policy combination mix. The man-
agement of capital flow in EA financial markets though
is within the same plane of A and E, the adjustment
process for central banks and financial regulators is done
via the distance between D to E. As E stays as the centre
of the Mundell-Fleming model, the point E would inter-
face with points D and A. The flow of policy is captured
between a no capital mobility point of A or a full capital
mobility point of D (see Figure 2).
In both extreme cases, point E plays an integral role of
adjusting the policy-driven space. The policy combina-
tion mix takes into account the external and internal en-
vironment and the adjustment is done accordingly.
Within the framework of the Mundell-Fleming model
and taking into account of points A, D and E, the distor-
tion to capital mobility in the EA framework is identified
by incorporating risk premium on capital mobility. Risk
premium in the form of barriers to capital mobility ṕ
which is the the interest rate that onshore investors must
pay to foreign investors. The risk-free rate in the eco-
nomy, ᶉ is the premium that foreign investors must pay to
domestic investors for parting with liquidity. In the
Mundell-Fleming model, ᶉ is determined in the money
market for a given real output, prices, and money supply.
Given the risk premium, the exchange rate e incorporates
ṕ, implying barrier of capital mobility that foreign inves-
tors face in investing in the domestic financial market.
Therefore risk premium
ṕ = f (ᶉ,e). (1)
where fᶉ > 0 and fe > 0. Higher interest rates ᶉ in the case
of tightening of monetary policy in the economy results
in an increase in the capital mobility risk premium
Mark et driven spac
e
&
Full capital mobility
D
No capital
mobility
A
*
Policy driven space
E
Figure 2. Market driven, policy driven, capital mobility.
ṕ and depreciation of the exchange rate is priced into the
capital mobility risk premium. As e increases it is identi-
fied as exchange rate depreciation and as e decreases it is
identified as exchange rate appreciation.
The model incorporates aggregate demand and supply
as reflected by the IS curve, given as
Y = D(Y, ᶉ, e) + G + NX(Y,e) (2)
where,
0
ee
DNX

 (3)
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S. RAMANATHAN, K. TENG 598
If, e < ê
The equilibrium in the money market is reflected by
the LM curve as
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and other high, referred as e and e. The two vertical
M/P = L(ᶉ, Y) (4)
The price level P is an exogenous component while
monetary policy is conducted by changing the money
supply M.
The balance of payments or the BP curve is identified
as
BP = NX(Y, e) + KA(ᶉ − r*, ṕ − ṕ* ) (5)
where,
0
epe
NXKA p (6)
If e > ê
where r* and ṕ* is the interest rate and risk premium at
equilibrium, whereby
KAᶉ + KAppᶉ > 0 (7)
If ᶉ < r*
And net exports NX have a positive relationship be-
tween income Y and the exchange rate e.
In the Mundell-Fleming model, capital flows KA in-
crease when interest rate differentials ᶉ − r* widen. Gray
and Malone (2008) [7] indicate, in the case of risk pre-
mium differences ṕ − ṕ* which widens, capital flow will
decrease given the risk of decline in investments and
general risk aversion to investments.
The standard BP model in the Mundell-Fleming model
while applies in a free capital mobility framework is in-
stead curved in the context of EA financial markets when
it incorporates points A, D and E. Given the backward
bending BP curve, two equilibriums exists for each value
of the exchange rate when taking the IS curve as fixed.
The first equilibrium at point F occurs when ᶉa < r* at the
lower half of the BP curve and the second equilibrium is
at point G when ᶉb > r* at the upper half of the BP curve
(see Figure 3).
Appropriate fiscal and monetary policy is used to ob-
tain any point along the BP curve but it will be impossi-
ble to achieve a level of output higher than point H on
the BP curve without causing exchange rate depreciation.
For a given exchange rate ê , the money supply necessary
to obtain point F equilibrium is by MA(ê), and the money
supply necessary to obtain point G equilibrium is by
MB(ê). Caballero and Panageas (2005) [8] indicate that
the backward bending IS curve occurs if households
practice precautionary savings and reduce consumption
in response to capital mobility risk premium being in-
corporated into the exchange rate. Corresponding with
the ISBP curve, equilibrium in the output and foreign
exchange market comprises of two backward bending
curves. In such circumstances with fiscal and monetary
policy, two equilibrium exchange rates exists, one low
L H
F
G
Y
ᶉ
LM
IS
ᶉ
b
r
*
BP < 0
BP > 0
B
P
BP < 0
BP > 0
BP < 0
Y
e
e
H
e
L
ê
LM (M =M
B
(e
L
)) LM (M =M
A
(e
H
))
ISB
P
H
ᶉ
a
Figure 3. Changes in monetary policy and risk of exchange
nes of the LM curve is consistent with monetary poli-
rate disequilibrium.
li
cies of


B
L
M
Me (8)
and

AH
M
Me (9)
The arrows on the LM curve indicate the
m
onetary policy corre-
sp
direction of
ovement of exchange rates that is out of equilibrium
where the space left of the ISBP curve intersects in two
places with the G equilibrium on the LM curve, the BP <
0, and exchange rates are increasing. In the space be-
tween the left hand and right hand of the ISBP curve, the
BP > 0, exchange rates are decreasing. To the right of the
right hand of the ISBP curve which intersects in two
places with F equilibrium on LM curve, the BP < 0 and
exchange rates are increasing.
In an environment of tight m
onding with M = MB and ᶉb > r*, the stable equilibrium
for exchange rates is at eH, but is unstable for exchange

S. RAMANATHAN, K. TENG
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599
3. Conclusion
l mobility being a factor that sh
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< r*, the stable equilibrium for exchange rates is at eL but
is unstable for exchange rate eH as excessively loose
monetary policy could induce a currency crisis.
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risk premium on capital mobility can be reduced gradu-
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