Robert A. Mundell
Robert Mundell was awarded the 1999 Nobel Prize in economics “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”
In much of the work on macroeconomics before Mundell’s work of the early 1960s, economists assumed—implicitly or explicitly—a closed economy, that is, an economy with no trade with other countries and no capital movements between countries. This was never a good assumption, and it became an even worse assumption as trade and capital flows expanded relative to various countries’ gross national products. Possibly because he grew up in Canada (even then America’s major trading partner) and did his undergraduate education at the University of British Columbia, Mundell was more aware than most American macroeconomists of the importance of international trade and international capital flows. The vast majority of Mundell’s work over his lifetime has been on some aspect of trade or capital flows.
One of the first major questions Mundell addressed was how governments should stabilize economies—keeping them growing while avoiding high inflation—in a world of trade and capital flows. He showed that when the exchange rate is fixed, as it was throughout the 1950s and 1960s between all major trading countries, stabilizing the economy with monetary policy is futile. The reason is that a government that fixes its exchange rate against other currencies must be prepared to provide whatever amount of money is demanded at this fixed price. This means that monetary policy is essentially passive. A government that wants to stabilize the economy must thus use fiscal policy—that is, changes in taxes or government spending.
Mundell also considered the case of floating exchange rates. At the time this was regarded as a theoretical curiosum because, as mentioned, all major trading countries had fixed their exchange rates with each other. But Mundell’s native Canada had floated its dollar from 1950 to 1962. Possibly for that reason, and possibly because Mundell had a sense of the future, he thought it worthwhile to consider the floating exchange rate case. (Major countries’ exchange rates have floated since the early 1970s.) Mundell showed that if the country has a floating exchange rate, then the government has much more ability to use monetary policy. On the other hand, fiscal policy now becomes impotent. If the government wants to increase aggregate demand by increasing government spending, for example, then, if it does not change monetary policy, the increase in the exchange rate due to the increase in aggregate demand reduces exports. Thus, all fiscal policy can do is change the composition of aggregate demand, not its level. The model Mundell used in 1960 to show this is now called the Mundell-Fleming model, after Mundell and Marcus Fleming,1 who developed a similar, though less extensive, model around the same time.
Mundell also did some early work in what is now known as “the monetary approach to the balance of payments,” which was actually laid out in rudimentary fashion by eighteenth-century economist David Hume. Mundell showed how, with fixed exchange rates, an economy will adjust as balance-of-payments surpluses or deficits cause changes in the money supply. Assume, for example, that capital moves across borders slowly. Then assume that the Federal Reserve increases the domestic money supply to reduce interest rates. With interest rates lower, domestic spending increases and imports increase. The resulting balance-of-payments deficit will cause money to leave the country, which in turn will cause domestic demand to fall, bringing the balance of payments back toward equilibrium. The net long-term result is a higher price level and no real economic effects.
Mundell also considered which government policy “tool” should be used on which policy “target.” He showed, contrary to what many economists before him had believed, that when exchange rates are fixed, monetary policy should be used to ensure equilibrium in the balance of payments (also known as the “external balance”), and fiscal policy should be used to adjust aggregate demand to attain full employment (“internal balance”).
In thinking through all these issues of assigning tools to targets and of fixed versus floating exchange rates, Mundell pointed out the so-called incompatible trinity: (i) unregulated mobility of capital, (ii) a particular fixed exchange rate, and (iii) a particular price level. Mundell showed that, at most, only two of these can be achieved. This has become standard thinking among economists and policymakers. It means that a government that wants, say, to keep inflation low and allow free capital movement must settle for a floating exchange rate, which is what most governments now do most of the time.
Mundell’s other big idea in the 1960s involves optimum currency areas. Rather than take it as given that each country should have its own currency, Mundell noted that if states within countries all shared the same currency, more than one country could do the same. Again, this seemed like a theoretical curiosum at the time (1961), but as the history of the euro has shown, it is anything but.
Mundell cited the reduction in transactions costs for trade across borders and the related ease of knowing various prices as the major advantages of a currency area (see monetary union). The major disadvantage, he noted, is the difficulty of maintaining full employment when one country suffers from some event that other members of the currency area do not suffer from. What if, for example, Canada and the United States are in a currency area, but the demand for softwood lumber suddenly declines? This would hurt Canada proportionally much more than the United States and, with a floating exchange rate, Canada could let the value of the Canadian dollar fall and save somewhat on the need for Canadian lumber workers’ wages to fall. But with Canada and the United States in the same currency area—the ultimate in fixed exchange rates—the Canadian dollar cannot fall relative to the U.S. dollar because they are the same dollar. One immediate implication, noted Mundell, is that high labor mobility (i.e., allowing workers to move from one country in the currency area to another country in the area) is key so that workers can have an easier time finding jobs. Of course, the euro is now the world’s largest currency area, and, in line with Mundell’s thinking, many EU supporters are advocating that workers be free to move from one EU country to another. Opposition to such worker mobility, though, was strong among French voters who voted down the EU constitution in 2005.
The issue of mobility of labor also dovetails with another issue to which Mundell contributed. He showed that if labor and capital are mobile across national borders, then even if there are trade barriers, labor and capital can shift to equalize prices of tradable goods. This means that trade barriers lead to more movement of labor and capital.
Mundell was and is an ally of various supply siders who not only want to use fiscal policy to keep the economy growing—which is consistent with his original 1960s insight—but also want a particular fiscal policy: namely, keeping marginal tax rates low or cutting them to a low level. In his Nobel address,2 Mundell highlighted the fact that inflation during the late 1960s and the 1970s had pushed people into higher and higher tax brackets, even when their real income had not increased. In the early 1970s, Mundell advocated that Canada’s tax brackets be indexed to inflation so that inflation alone would not increase people’s marginal tax rates, and the Canadian government adopted this policy. In 1981, President Ronald Reagan and Congress also adopted indexing, effective in 1985.
Mundell earned his Ph.D. from MIT in 1956. His early positions were at Stanford University, the Johns Hopkins Bologna Center of Advanced International Studies, and the International Monetary Fund. From 1966 to 1971, he was a professor of economics at the University of Chicago. He has been on the faculty of Columbia University since 1974.
About the Author
David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.
J. Marcus Fleming, “Domestic Financial Policies Under Fixed and Under Floating Exchange Rates,” IMF Staff Papers 9 (1962): 369–379.