Theory Of Topic - Exchange Rate Determination And The Mundell-Fleming Model

With the progress in the world economy and with the entire world becoming united due to several progressive ideologies, the exchange rate between the currencies of countries has assumed several changes over the period of time, with some countries going in for better exchange rates in comparison with others.

However, there have been drastic changes in some countries with the integration of the world economy, which brings in links between financial institutions.

In the traditional model of exchange rate determination, it is assumed that domestic interest rates will remain unaffected by any fluctuations in the world currency rates. However, with the modern Mundell-Fleming system, the entire world is seen as one and changes occurring in the external world have influences on any country's currency values.

Certain presumptions are made with regard to the Mundell-Fleming model which pertains to assuming that with the increase in income, taxes and savings should naturally face an increment. However, domestic pricing is kept intact due to the domestic output and its supply remaining constant. In a concern, investment patterns influence the money involved and also determine the interest rates offered by the concern.

The Mundell-Fleming model can be calculated based on the equation

Y = C + I + S + NE

Where C is the consumption pattern exhibited in the particular society or among consumers, I indicate the investment in terms of money or currency of the particular country, G refers to the expenditure of the governments of the respective countries and NE connotes net exports of the country. 

All the factors have an influence on the Mundell-Fleming equation with increase in government spending tending to increase the rates of interest and also there will be a higher rate of income available. These factors, when combined will determine the net worth of a country.

Under the Mundell-Fleming model, the country is supposed to be called an open economy. In order to develop the economy of countries or households, there should be linking of investments such that countries where the returns or yields are higher could return greater rates of interests. The same policy could be followed by several investors, of course with the involvement of some degree of risk, to invest in several countries.

The assumptions made while investing in any country's business are that the country's economy is a small, open economy, that the rates at which taxes are levied are same throughout the world and that investment made by foreign investors are not subjected to risks in any country in terms of risks or restrictions of transfers.

The investors in any country expect high rates of interest which implies that any country would offer higher rates of interest for the investors and which would increase the rate of investment in any country. With the policy of the country being open-minded for the investors, the investors

Perfect rate at which the capital of the investor is made mobile in the country is highly crucial in the Mundell-Fleming model to determine the returns on the investment.

Problems Encountered In Solutions To   Exchange Rate Determination And The Mundell-Fleming Model Problems

Getting the basic concepts of Mudell-Fleming model and solving the equation may be felt tough for the students to manage in order to solve problems or perform better in assignments.

The assumptions made pertaining to the Mundell-Flaming model while investing in the business of another country needs to be imbibed well by the students as they may go wrong with the assumptions and in the calculation of the interest rates offered by other countries should be learned well before embarking on such ventures.

The students will also face constraints in acquiring information on domestic pricing as well as taxes and savings on the investments made and thereby how it will influence the Mundell-Fleming model.  Also the students should be aware of the risks involved in the investments made in other countries with regards to the rate of interest and the capital invested.

There should also be better level of understanding on how the rates of investment and capital will increase by following the open-minded economic policy.

Thus students should be thorough with the intricacies of the Mundell-Fleming model with regards to the assumptions of greater rates of interest.

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