While many students may accept the model’s conclusions based on its longevity and the professions’ widespread adherence (which may be wise), I was naturally skeptical. What are the model’s assumptions? Will different monetary regimes alter the conclusions? What does it even mean to have “an independent monetary policy”? In search of answers, I sought out one of the original sources.
“Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates” by R.A. Mundell was published in The Canadian Journal of Economics and Political Science all the way back in November 1963. At the time the world’s major industrial nations were adhering to the Bretton Woods system, under which the U.S. dollar was convertible to gold and all other countries involved tied their currencies to the U.S. dollar. Recognizing the expansion of global trade taking place, Mundell sought to outline “the theoretical and practical implications of the increased mobility of capital. (p.475)” To simplify the conclusions Mundell begins by assuming “the extreme degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad. (p.475)” He further assumes “that all securities in the system are perfect substitutes” and therefore the “existing exchange rates are expected to persist indefinitely. (p.475)” The last assumption presently worth noting is that “Monetary policy will be assumed to take the form of open market purchases of securities. (p.476)”
While these assumptions may have been valid within the Bretton Woods system, that system was terminated in 1971 by President Nixon unilaterally canceling the direct convertibility of the U.S. dollar to gold. Since then the U.S. and several other major industrial nations have been operating using a fiat currency. Under this new monetary regime, without convertibility, there is little reason to believe that all currencies are even near perfect substitutes or that exchange rates will persist for any defined period of time. Furthermore the end of the Bretton Woods system marked the beginning of inflation targeting as the primary method of monetary policy.
Monetary policy was still enacted through open market operations after the regime change, but those operations were now performed to maintain an target interest rate. The more significant difference is that using interest rates as the primary tool for targeting inflation ensured interest rates would be maintained at levels different from those prevailing abroad. This “corridor” system of inflation targeting would last in the U.S. for nearly 40 years before being replaced by a “permanent floor” system in 2008.
Breaking with previous tradition, the “permanent floor” system (also known as interest-on-reserves regime) allows central banks to control interest rates separate from engaging in open market operations. Interest rates are now (largely) determined by the interest-on-reserves (IOR) rate, while excess reserves give the central bank freedom to let the monetary base fluctuate more widely.
Returning to Mundell’s paper, he begins by analyzing monetary policy under flexible exchange rates:
“Consider the effect of an open market purchase of domestic securities in the context of a flexible exchange rate system. This results in an increase in bank reserves, a multiple expansion of money and credit, and downward pressure on the rate of interest. But the interest rate is prevented from falling by an outflow of capital, which causes a deficit in the balance of payments, and a depreciation of the exchange rate. In turn, the exchange rate depreciation (normally) improves the balance of trade and stimulates, by the multiplier process, income and employment. A new equilibrium is established when income has risen sufficiently to induce the domestic community to hold the increased stock of money created by the banking system. Since interest rates are unaltered this means that income must rise in proportion to the increase in the money supply, the factor of proportionality being the given ratio of income and money (income velocity). (p.477)”The earlier review of changes to the monetary regime makes it clear that this causal chain is fraught with errors. Starting from the beginning, “an increase in bank reserves” does not cause “a multiple expansion of money and credit” (see here) nor will it lead to “downward pressure on the rate of interest.” If interest rates are unchanged, there should be no outflow of capital and no subsequent depreciation of the exchange rate. The balance of trade therefore remains the same and the “multiplier process” never takes place. In complete contrast to Mundell’s conclusion, monetary policy (effectively QE) has no effect on income or employment under flexible exchange rates.*
Switching to monetary policy under fixed exchange rates:
“A central bank purchase of securities creates excess reserves and puts downward pressure on the interest rate. But a fall in the interest rate is prevented by a capital outflow, and this worsens the balance of payments. To prevent the exchange rate from falling the central bank intervenes in the market, selling foreign exchange and buying domestic money. The process continues until the accumulated foreign exchange deficit is equal to the open market purchase and the money supply is restored to its original level. (p. 479)”As previously stated, the creation of excess reserves no longer affects the interest rate. This prevents the rest of Mundell’s process from taking place, but nonetheless results in the conclusion that monetary policy is ineffective.
This fixed exchange rate simulation serves as the basis for the Impossible trinity. Given free capital flows and a fixed exchange rate, the central bank is forced to counteract open market operations with equivalent opposing actions in the foreign exchange market. Since the money supply is ultimately unchanged, the country is said to have relinquished its monetary policy independence. However, under the current monetary policy regime this outcome is drastically altered.
Mundell examines the common case of a country trying “to prevent the exchange rate from falling. (p. 479)” Using a “permanent floor” system the central bank can maintain its interest rate policy and a fixed exchange rate, but faces limitations since “the central bank intervenes in the market, selling foreign exchange and buying domestic money. (p. 479)” One limitation arises when the central bank runs out of salable foreign exchange. Another limitation occurs once the central bank drains all excess reserves from the system, forcing it to forgo either its interest rate or exchange rate policy. These limitations suggest the Impossible Trinity will hold in the long run.
Now consider the less frequent and more recent case of a country trying to prevent its exchange rate from rising. The central bank manipulates the market exchange rate by buying foreign exchange and selling domestic currency. Contrary to the previous example, the central banks actions suddenly appear unlimited. Since the central bank can always create new reserves, it faces no limitations in selling domestic currency. Meanwhile if the demand to trade foreign exchange for domestic currency dries up, then the central bank will have successfully defended its peg. Therefore, as long as the Fed is willing to accept the risks associated with a balance sheet full of foreign exchange, the Impossible trinity is no longer impossible.
The Impossible trinity stems from Mundell and Fleming’s attempt to incorporate an open economy into the IS-LM model. Their analysis reflects an understanding of the Bretton Woods system, which ruled monetary policy at that time. Today’s monetary system and policy operations are a far cry from the Bretton Woods system, yet the Mundell-Fleming model has not been updated accordingly. Beyond minimizing the effects of monetary policy, the transformation of monetary policy to a “permanent floor” system has made the previously impossible, possible.
*In reality, monetary policy (QE) will affect income and employment to some degree for reasons not outlined by Mundell. However, those effects are likely to be small and could be either positive or negative.
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Mundell, R. A. "Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates." The Canadian Journal of Economics and Political Science 29.4 (1963): 475-85. Print.