Free Flows of Capital and the Mundell-Fleming Model Essay

Free Flows of Capital and the Mundell-Fleming Model


            As what I have learned from the video and the textbook, it can be said that perhaps, globalization might have arisen due to increased world trade.  However, for more than a decade now, the movement of money has quickened faster driven by financial market reforms and facilitated by information technology.  Relative to this, this paper will discuss the free flows of capital brought about by increased world trade and globalization and its relationship with the Mundell-Fleming model.  This topic is significant because in this increasingly globalized economy, we are all experiencing free flows of international capital.  According to Yergin and Stanislaw (2002, p. 416), all the participants involved in the new global economy — investors, consumers, lenders – have to uphold a clear-eyed evaluation of the dangers of the market.  Hence, the free flows of capital are important in this integrated global marketplace.

Free Flows of Capital

            As maintained by DeLong (1998), all of us are experiencing the benefits caused by free flows of international capital.  According to him, these benefits are enormous.  First, the capacity to borrow overseas prevented the Reagan shortfalls from devastating the economic growth of the United States.  Moreover, the capacity to borrow from a foreign country has allowed the successful promising and up-and-coming economies to either double or triple the speed at which their living standards and productivity levels meet to the industrial core.  However, DeLong (1998) also said that the free flow of financial capital is providing us one primary international financial crisis every two years as well.

            Some people believe that the Asian financial crisis in the 1990s occurred because the United States urged the Asian nations to lift capital controls. According to Stanley Fischer, former Deputy Managing Director of the International Monetary Fund (IMF), partly responsible for what happened was that capital controls were removed incorrectly.  As what I have seen from the video, one of the lessons, which could be learned from this occurrence is that if a country is going to open up its capital account, it should establish the long-term money first, then let the equity investment pour in, and then it must enable the long-term borrowing pull in, and also let the foreign direct investment, selling and buying companies come in.  This means that a country should just open up at the short term when its financial system is sound.

            According to the interview of Dr. Mahathir bin Mohamad of Malaysia as supplement in the video, long before globalization has become a buzzword, several delegations from the U.S. came to Malaysia and asserted to the Malaysian government to permit American banks to operate or function as national banks in Malaysia.  However, the Malaysian government felt that if they will give in to the desires of the U.S., Malaysia’s own businesses will certainly be swallowed up by American companies.

            In my opinion, I think that globalization is merely benefiting the rich countries.  Take for instance the case of currency trading.  If it is going to be advantageous, it should be regulated so that it will not enrich the rich countries to the detriment of the poor countries.  I think that the entire process of currency trading slowed down so that smaller countries could adjust to globalization and its consequences.

            Fiscal policy has a big role in globalization’s effect on the country.  According to the Mundell-Fleming model of open economy, even with fixed exchange rates and capital mobility, fiscal policy could still be efficient.  This model combines the good market (IS), the foreign exchange market (FE) and the money market (LM) (please see attached graph).  Thus, according to this model, the country still has an instrument which it can use to control or manage the economy.  This means that even if an independent central bank can invalidate a fiscal growth in a closed economy, when exchange rates are fixed and capital happened to be mobile, monetary policy will not be effective.  In this scenario, the country could stimulate the economy so that an independent central bank can do little in return.  Nevertheless, paradoxically, globalization restricts central banks from restraining spendthrift countries.

            Thus, to prevent a financial crisis in this globalized world, nations that aspire to profit from the huge benefits of global capital flows should ensure that they do not damage or harm their own capability to manage crises. According to DeLong (1998), in the present international monetary system, it is presumed that one response to a crisis will be devaluation.  This is in view of the fact that the world economy has indicated that it is no longer ready to pay as much for a nation’s capital or goods unlike before, devaluation is a means of decreasing the price of an entire country’s goods. Therefore, the first step that a nations wanting to profit from the huge benefits of global capital flows country should do is set up a system to distinguish and punish home-country organizations and companies that make use of money-center currencies, given that a huge amount of such loan is what turns a change in animal spirits by foreign shareholders from an displeasure to an upheaval.

Next, there should be a good system of domestic banking regulation, which will find out –and shut down –financial organizations that are bankrupt, and that consequently have strong reasons to engage in dangerous but unprofitable ventures.


            In conclusion, as what Yergin and Stanislaw (2002, p. 18) said, the changes happening now should denote the creation of the first truly global economy, interconnected and integrated.  I believe that for globalization to be fair and effective there should be freedom of movement across countries, whether the capital is in the form of money or in the form of people or labor. #

Graph –  The Mundell-Fleming Model





DeLong, J.B. (1998). “Helping Countries Prepare for International Capital Flows,” USIA Economic Perspectives.

PBS.  Commanding Heights:  The Battle for the World Economy.  Video produced by WGBH.

Yergin, D. and J. Stanislaw.  (2002).  Commanding Heights:  The Battle for the World Economy.  NY: Simon and Schuster.