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Small-Country Mundell–Fleming (IS/LM/BP) Model Predictions Under Both Fixed and Flexible Exchange Rates: Evidence from Australia and S. Korea

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  • Jonathan Edward Leightner

    (Hull College of Business Administration, AllGood Hall, Summerville Campus, Augusta University, 1120 15th Street, Augusta, GA 30912, USA)

Abstract

The small-country IS/LM/BP (Mundell–Fleming) model predicts that monetary policy is totally ineffective in countries with fixed exchange rates and super-effective in countries with flexible exchange rates. Furthermore, this model predicts that, under fixed exchange rates, fiscal policy is stronger the more mobile capital is in terms of moving in and out of the country, but it predicts the opposite for countries with flexible exchange rates; fiscal policy is stronger the less mobile capital is. This paper tests these predictions by applying reiterative truncated projected least squares (RTPLS) to quarterly data from Australia and the Republic of Korea when they employed fixed and then flexible exchange rates. RTPLS produces a separate total derivative estimate for each observation, where the differences in these estimates are due to omitted variables. By doing so, RTPLS makes it possible to see how the estimated relationship changes over time. I found that the effectiveness of monetary policy was not zero under fixed exchange rates but that its effectiveness did increase when Australia and S. Korea switched to flexible exchange rates. Under flexible exchange rates, I found that the effectiveness of fiscal policy was statistically higher than zero for both countries, which conflicts with the assumption of perfect capital mobility.

Suggested Citation

  • Jonathan Edward Leightner, 2024. "Small-Country Mundell–Fleming (IS/LM/BP) Model Predictions Under Both Fixed and Flexible Exchange Rates: Evidence from Australia and S. Korea," JRFM, MDPI, vol. 17(11), pages 1-20, November.
    • Handle: RePEc:gam:jjrfmx:v:17:y:2024:i:11:p:495-:d:1514933
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    References listed on IDEAS

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    1. Javier Ortíz & Carlos A. Rodríguez, 2002. "Country Risk and the Mundell-Fleming Model Applied to the 1999-2000 Argentine Experience," Journal of Applied Economics, Universidad del CEMA, vol. 5, pages 327-348, November.
    2. Charles Yuji Horioka, 2024. "The Feldstein–Horioka Puzzle or Paradox after 44 years: a fallacy of composition," The Japanese Economic Review, Springer, vol. 75(3), pages 383-404, July.
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