Output, Interest and Changing Exchange Rate Regimes

Abstract

We now enter into the later phase of the Bretton Woods system, broadly speaking from the midst of the sixties up to 1973 when the Bretton Woods system came to an end. This period was characterized by significantly increasing capital flows, speculative exchange rate attacks and also real disturbances. The model used at the time to understand the evolution in international trade in goods and financial assets was the so-called Mundell-Fleming model, based on works of Mundell and Fleming in the early 1960s.¹ Yet, though the basic Mundell-Fleming approach is now surely outdated, modern variants of this approach (of the IS-LM-PC type) still have their place in the literature on fiscal and monetary policy in open economies, at the very least as a point of reference for other contemporary approaches that stress intertemporal aspects, no-arbitrage conditions as representations of asset market equilibria and rational capital gains expectations; see McKibbin and Sachs (1991) for an example. It is therefore still of use to start from and to consider the basic form of the Mundell-Fleming approach to trade and capital mobility, its rich set of implications for the use of fiscal and monetary policy under various central banking and exchange rate regimes and its eventual evolution towards a more complete and coherent IS-LM-PC approach, including exchange rate dynamics, to the understanding the economic interactions in the world economy.