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The Nobel Series: Father of Euro

Chiefly known for dynamic analysis of fiscal and monetary policy under different exchange rate regimes, Robert Alexander Mundell made fundamental contributions to international macroeconomics, guiding trade and economic policies to date

The Nobel Series: Father of Euro
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The Nobel Prize in Economic Sciences in 1999 was awarded to Robert A Mundell, who was then at Columbia University, New York, USA, "for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas".

Mundell did his undergraduate studies at the University of British Columbia in economics and Russian. After this, he did his postgraduate studies at University of Washington in Seattle and continued at MIT and London School of Economics. Mundell received his PhD from MIT in 1956 with a thesis on international capital movements. He went on to do his postdoctoral work at the University of Chicago in 1957 and simultaneously taught at Stanford and Johns Hopkins University. Between 1961 and 1963, Mundell did a stint in the research department of IMF, where he met Fleming and collaborated with him in proposing the Mundell-Fleming model. He returned to the University of Chicago as faculty, where he stayed from 1966 to 1971. Thereafter he was a professor at the Graduate Institute of International Studies in Geneva till 1974. After this, Mundell has been at Columbia University in New York since 1974.

In this paper, we will review the main works of Mundell and their applications to public policy.

Main works

Mundell's most innovative and original research was in the area of international macroeconomics wherein he gave a sound theoretical framework for carrying out fiscal and monetary policy in open economies. This also came to be known as the Mundell-Fleming model. His other main work was in optimal currency areas, on which the European Monetary Union was based.

In an article, 'Capital mobility and stabilization policy under fixed and flexible exchange rates' (1963) which Mundell wrote in 'Canadian Journal of Economics and Political Science', the Mundell-Fleming model was first proposed. In this article, the effects of stabilisation policy (fiscal and monetary policy) were analysed in different exchange rate regimes. Along with this article, Mundell wrote other papers which were put together in his book 'International Economics' (1968). In these papers, Mundell developed his model and analysed the impact of fiscal and monetary policies in a small open economy. Mundell proposed the modification of the IS-LM model which was originally put forward by Hicks. While Hicks' model was for a closed economy, Mundell introduced trade and capital movements in the model. Another important assumption in the Mundell-Fleming model was that it applied to a small open economy. In other words, it is assumed that the interest rate is given for the economy and it can buy and sell as much foreign currency as it wants at this interest rate. A corollary of the Mundell-Fleming model, frequently referred to as the Mundell-Fleming trilemma, is that an economy cannot maintain a fixed exchange rate, free capital movement and an independent monetary policy at the same time: only two of these can be maintained.

More specifically, Mundell introduced the net exports function in the IS-LM model. Net exports are a function of the exchange rate — the higher the exchange rate, the lower the exports. This gives the modified IS curve, where output is a function of the exchange rate. As for the LM curve, it is not upward sloping as in the Hicks' model. It is a vertical curve, since the rate of interest is given and the output is determined independently of the exchange rate. The intersection of the modified IS and LM curves gives us the equilibrium exchange rate and output, or aggregate demand.

Having set out the model, Mundell showed that under a floating exchange rate, a country would have to use monetary policy, since fiscal policy would have no effect on output. This is because of the vertical LM curve and the fixed rate of interest. Hence, if there is a fiscal expansion, the IS curve shifts towards the right. In the modified IS-LM model (with output on the x-axis and exchange rate on the y-axis as opposed to output and rate of interest in the original IS-LM model), this rightward movement of the IS curve only leads to an appreciation of the currency. This results in a fall in net exports, which cancels the expansionary effect of the fiscal policy. On the other hand, monetary policy works in a small open economy with a floating exchange rate. However, it does so by influencing the exchange rate, since the interest rate is fixed, as we saw above. An increase in money supply reduces interest rate, leading to capital outflow as investors seek higher returns abroad. While the interest rate comes back to the original world interest level, it leads to a depreciation of the currency (since investing abroad requires converting domestic currency into foreign currency and leads to a rise in the supply of the domestic currency leading to its depreciation). This depreciation stimulates exports and leads to higher income.

On the other hand, in a fixed exchange rate regime, fiscal policy works, but monetary policy is ineffective. The reason is that a government that fixes its exchange rate against other currencies must be prepared to provide whatever amount of money is demanded at this fixed price. In terms of the IS-LM model, an expansionary monetary policy leads to an outward shift of the LM curve, which would make capital flow out of the economy. The central bank would have to instantaneously intervene by selling foreign money in exchange for domestic money to maintain the exchange rate. The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the LM curve to shift to the right, and the interest rate remains equal to the world rate of interest. Hence monetary policy doesn't work and one has to rely on fiscal policy to raise growth rates.

The other main work of Mundell was on optimal currency areas. In 1961, Mundell wrote an article on optimal currency areas and asked whether a common currency could be designed for a few countries. He argued that such a move would benefit the members of the common currency area in terms of "lower transaction costs and less uncertainty about relative prices". On the other hand, the drawback was the increased challenges of maintaining unemployment, when changes in demand led to lower wages in a certain country. He therefore argued in favour of high labour mobility. Mundell's work inspired the European Monetary Union and the resultant Euro as the common currency of the members. In fact, Mundell is also called the Father of the Euro.

Before his 1963 article, Mundell had written two articles in 1960, 'The Pure Theory of International Trade' in 'American Economic Review' and 'The Monetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates' in the 'Quarterly Journal of Economics'. In the former article, Mundell analysed "the transfer problem", whereby a country pays reparations to another, and the impact of such payments on the global economy. The paying country produces at greater cost and less income; the receiving country gains in income but not productivity and there is less to buy, including after-tax investment paper from the foreigner; and crucially, capital flows adjust to a comparatively slower-growing world economy. The latter article was a forerunner to the Mundell-Fleming model which was presented in the article in 1963.

Mundell's Chicago graduate student was another well-known trade economist: Rudiger Dornbusch. Analysing Mundell's work, he commented: "No matter how sovereign governments try to be in their economic policy, if their countries are integrated with the world at all, international capital movements will "vote" on domestic policy changes without regard to anything but the pure economics of the matter".

Mundell's work also modified the two dominant thoughts prevailing in economics in the 1970s — Keynesianism and monetarism. As discussed above, Mundell showed that capital movements and exchange rates will have an impact on the way fiscal and monetary policy is conducted.

Mundell had made several other contributions to macroeconomic theory: his Mundell-Tobin effect suggests that nominal interest rates would rise less proportionately than inflation because the public would hold less in money balances and more in other assets, which would drive interest rates down. Mundell also contributed to international trade theory suggesting that the international

mobility of labour and capital tends to equalise commodity prices among countries, even if foreign trade is limited by trade barriers. This may be regarded as the mirror image of the well-known Heckscher-Ohlin-Samuelson result that free trade of goods tends to bring about equalisation of the rewards to labour and capital among countries, even if international capital movements and migration are limited. An implication of this is that trade barriers stimulate international mobility of labour and capital, whereas barriers to migration and capital movements stimulate commodity trade.

Finally, Mundell was also with the analysis of the Gold standard and how it was the mismanagement by the US Federal Reserve that led to the breakdown of the Gold standard as well as the Bretton Woods system of fixed exchange rates. He is known to have predicted that the future would bring forth some form of Bretton Woods without the US dollar.

Conclusion

Robert Mundell passed away on April 4, 2021, and left behind a considerable body of original work. Some call him the greatest economist of the century after John Maynard Keynes. The Mundell-Fleming model continues to be the basic model to guide macroeconomic policy management in an open economy.

Mundell, along with Friedman, was closely associated with the economic policy management in President Reagan's administration. While Friedman's ideas provided the push for Reagan's deregulatory drive, Mundell gave the intellectual fuel for 'supply side economics', or 'Reaganomics', abetted by the popularising efforts of his disciple Arthur Laffer of the Laffer curve fame. Mundell was also known as the father of the Euro, which came out of his work on optimal currency areas.

Mundell's work was also prescient in that he accurately predicted the move to some form of flexible exchange rates for most countries in the 1960s itself, when fixed exchange rates ruled the roost within the Bretton Woods system. We know that international capital markets opened up and the Bretton Woods System broke down later, as predicted by Mundell.

Mundell's contribution moved from a static analysis of fiscal and monetary policy to a dynamic analysis. As we saw above, his dynamic analysis led to a useful heuristic for governments and central banks across the world: His analysis led us to the conclusion that monetary policy is linked to external balance and fiscal policy to internal balance. This also led to the widely accepted thumb rule of giving independence to central banks in matters relating to inflation management.

Of course, Mundell had his critics, who said that his models made simplistic assumptions such as price rigidity in the short run, and perfect capital mobility. While the shortcomings have been addressed by later researchers, the immense value of Mundell's work is unquestioned and continues to guide economic and trade policy even today.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal

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