The models have a higher level of microeconomic

The Strengths of the Mundell Flemming model are assessed as follows: The Mundell Fleming model manages to capture a real world figure of the increased economicintegration between economies.

Its mechanics provide us with a good base for other advancedmodels. The model assumes that prices are fixed and such an assumption has empiricalevidence which in turn provides a useful model to study short to medium term effects ofmacroeconomic policy in an open economy. However, the model is flexible in the sense that there have been modifications to the model toallow for flexible prices and wages.

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The model assumes easy capital mobility. Such an assumption does have relevance in theworld of today where the financial markets of the world are closely integrated and capital flowsacross the world have increased manifold. Add to this that FDI ( foreign direct investment ) flowsare a major source of growth in developing and developed economies. This simply proves thatcapital flows are not restricted by national borders. The inter temporal and monetary models have a higher level of microeconomic base. However,such models assume a high level of economic integration between economies which leads toprices being flexible. This is in turn supports no possibility of international goods arbitrageopportunity. However, there is sufficient evidence against the law of one price.

Prices do nottend to be so flexible which proves that arbitrage operates with a lag and that the Mundell Flemingmodel is more suitable for medium to short term analysis. It offers valuable insight into the behaviour of an economy when there is disturbance or a policychange. The outcomes predicted by the model can actually be observed in a economy withregards to short term considerations. The limitations of the Mundell Flemming model can be assessed as follows The fact that prices are fixed in the short to medium term has been proved to be correct byempirical evidence. However, if we use a consumer price index as proxy for the price thisassumption is not valid as the price index tends to fluctuate even in the short-medium term. The model assumes that we start in an equilibrium state. Such an assumption may beunreliable. Also, it limits the use of the model from a dynamic perspective and makes it moresuitable for a comparative study The assumption of easy capital mobility is not always suitable.

For example if we were toassume a country whose government or private sector is likely to default on its debt, such acountry would not attract capital flows at a reasonable rate of return (as the risk premium would behigh). Also, a lot of economies impose capital controls which restricts the flow of capital betweeneconomies. In the current world scenario where we see that protectionism is rising, these controlsmight grow. The model fails to define a sustainable level of domestic consumption. As per the model ifincome increases, consumption increases, imports increase which in turn leads to a currentaccount deficit. Such a deficit is financed by capital inflows. However, eventually such a buildup ofdebt may cause the consumption to decrease as the debt may become unsustainable and defaultsmay start occurring. The model does not pay regard to the type of imports and exports.

It is very much a possibility thatimports and exports are not impacted to the level as predicted by the model due to consumertastes and preferences. To have an impact on exports and imports we need to assume that theMarshall Lerner conditions hold. The model makes the assumption that whatever is the demand in the economy is supplied.The Aggregate supply curve is assumed to be flat. Such an assumption fails to help usmeasure the level of internal balance in an economy. We are unable to determine if theeconomy is near full employment or away from that point. For example, if we are near fullemployment, an expansionary monetary policy might not increase output as much as predicted bythe model as the scope to affect the real economy diminishes near full employment.

The only factor affecting capital flows is not the interest rate differential. A variety of otherfactors are important in determining whether capitals flows will take place or not. For example acountry with a high interest rate but with a weak domestic economy with regards to consumptionand investment will not attract a capital. 


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