A Theory for an Open World

Fortune issue: December 20, 1999

First Principles


A Theory for an Open World

By N. Gregory Mankiw

To say we live in a global economy is a cliché as trite as they come. Today everyone understands that a nation has to keep an eye on its neighbors when setting economic policy.

But this wasn't always so obvious. In the 1960s, U.S. imports were a mere 4% of GDP, compared with 14% now. Mainstream theories of monetary and fiscal policy mostly ignored international issues, assuming in effect that each nation was alone in the world. Columbia University economist Robert Mundell, a Canadian, knew otherwise. The analysis he developed in the 1960s won him this year's Nobel Prize in economics. More important, it remains the starting point for explaining how policy works in a global economy.

In the 1930s economist John Maynard Keynes said depressions and recessions resulted when people weren't spending enough to keep everyone employed. The solution, he argued, was to goose up spending any way we could. Fiscal policymakers could increase government purchases or cut taxes to spur consumption. The central bank could stimulate spending by expanding the money supply and lowering interest rates.

Mundell asked whether this Keynesian prescription would work in a world of perfect capital mobility, where investors were quick to move their funds from country to country to seek the highest return. What he learned was that capital mobility undercuts the power of either monetary or fiscal policy, depending on whether the country fixes its exchange rate (as the U.S. did in the 1960s) or lets it float freely (as it does today).

With a fixed exchange rate, monetary policy is the victim. When a central bank tries to combat a recession by expanding the money supply and lowering interest rates, international investors start taking their funds abroad to earn a higher return. This capital outflow puts downward pressure on the value of the currency. To keep the exchange rate fixed, the country has to use its foreign-currency reserves to buy back some of its own currency. That reverses the monetary expansion, leaving the economy where it started.

In contrast, if a nation lets its exchange rate float to whatever level the market determines, monetary policy works, but fiscal policy doesn't. When government spending is increased or taxes are cut, the resulting budget deficit pushes interest rates upward. International investors quickly respond to any rise in interest rates by bringing in funds from abroad, bidding up the value of the domestic currency. This currency appreciation makes domestic goods more expensive abroad and foreign goods cheaper at home, so exports fall and imports rise. The deterioration in the trade balance offsets whatever expansionary effect the fiscal policy might have had.

This theory of monetary and fiscal policy, called the Mundell-Fleming model, is now standard analysis. (Marcus Fleming, an IMF economist who developed the theory at about the same time as Mundell, died in 1976, and the Nobel is not given posthumously.) The model is found in undergraduate textbooks, including one of mine. And it is firmly in the minds of the world's policymakers.

The Mundell-Fleming analysis doesn't precisely describe the world of the 1960s, when it was proposed, or even the world today. Investors still keep most of their savings invested in their home country, regardless of the rates of return available overseas. But the analysis describes the world toward which we have been moving. Now that funds can be transferred from dollar- to yen-denominated assets with only a few clicks of a mouse, Mundell's assumption of perfect capital mobility looks downright prescient. This Nobel Prize was perfect for the dawn of the 21st century.


N. GREGORY MANKIW is a Harvard economics professor and author of Principles of Economics.