Robert Mundell is most widely known for his work on monetary dynamics in different exchange rate systems and the analysis of optimum currency areas.
Developed in the early 1960s, his ideas laid the foundation to further theoretical as well as empirical research which still prevails today.
Robert Alexander Mundell was born in 1932, in Kingston, Canada.
After his undergraduate studies at the University of British Colombia, Vancouver and the University of Washington, he completed his education at the London School of Economics and the Massachusetts Institute of Technology (MIT) where he received a doctorate in 1956 for his research on international capital movements. During this time, he was attracted to and influenced by the works of Paul Samuelson, Charles Kindleberger, Lionel Robbins and James Meade who would later became his doctoral father at the MIT. During the following years, he taught at several universities, such as the University of Chicago where he was made professor in 1966. Other stations included Stanford University, the Johns Hopkins Bologna Center of Advanced International Studies in Italy and the Graduate Institute of International Studies in Geneva, Switzerland. From 1974 he was affiliated with the University of Columbia, New York.He was the author of numerous articles and functioned as an adviser to the staff of several international institutions and governments, such as the International Monetary Fund, the United Nations, the World Bank and the European Commission. During his time at the University of Chicago he also became the editor of the Journal of Political Economy.
In 1999, after receiving several other prizes, awards and titles of honorary doctor, he was awarded the Bank of Sweden Prize in Economic Sciences in memory of Alfred Nobel, “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas”. The prize was especially devoted to Mundell’s work in the 1960s. At this time, most of the world was still operating in a fixed exchange rate system, while free capital mobility was just in its infancy.
His anticipation of the evolution of an international capital market as well as his work on currency unions were praised for their “almost prophetic foresight”. His extensions of the investment saving-liquidity preference money supply equilibrium (IS-LM) model to show the effect of monetary and fiscal policy in an open economy were described as both simple and decisive. His works on optimum currency areas were used intensively in the early efforts to create a common currency in Europe.Owing to his versatility, Mundell is also the co-originator of supply-side economics, most prominent during the Reagan administration. His work covers economic theory in various areas such as international trade, transition economies and the history of the monetary system. According to the Mundell-Tobin effect, a rise in expected inflation will reduce the demand for real money balances. Owing to an incomplete adjustment of the nominal rate, real interest rates will fall, leading to a portfolio shift in favour of real capital investment. Therefore, Mundell’s model shows that inflation expectations could have real economic effects. Nevertheless, he is clearly most renowned for his “Nobel works” concerning exchange rate policy and optimum currency areas, both of which have been developed further over the years.
Building on the closed economy IS-LM model of John Hicks, Mundell incorporates foreign trade and capital movements, hence opening up the model for a multi-country analysis. He complements the goods demand and money market equations with a balance-of-payment equation that captures trade and capital flows. For non-perfect capital markets, where domestic and foreign financial assets are no perfect substitutes, permanent interest rate differences thus create a flow of assets at a steady rate. This simple setting allows Mundell to extend the analysis of the IS-LM model in order to explain the (non-)autonomy and (non-)effectiveness of fiscal and monetary policy in an open economy under fixed or flexible exchange rates.
With perfect international capital markets, the balance-of-payment equation reduces to the no-arbitrage condition of interest rate parity.Rising domestic demand would traditionally raise the domestic interest rate, which in an open economy would trigger capital movements, resulting in an inflow of foreign capital, therefore forcing the local currency to appreciate. Mundell shows that, under fixed exchange rates, monetary policy is degraded to merely manage the composition of assets, whereas fiscal stimuli are amplified by the monetary policy measures induced by the goal of defending a given exchange rate level. The opposite holds for the case of flexible exchange rates; where in turn fiscal policy is dampened by exchange rate adjustments and the monetary policy becomes a powerful tool.
This leads to two conclusions: the first is known as the assignment problem and asks whether the central bank or the fiscal authority is responsible for internal or external balances, respectively. According to Mundell, this depends on the respective impact. Therefore, the speed of adjustment as well as the implied interest rate sensitivity is of special focus for his work. The second is known as the incompatible trinity and states that free capital mobility either allows for an external target, such as the exchange rate, or an internal target, such as the price level, but not for both simultaneously.
The open-economy IS-LM model (also named Mundell-Fleming model) played an indispensable role in teaching, research and economic policy advice for many years (Frenkel and Razin 1987). However, his theory has also been subject to debate. Obstfeld and Rogoff (1995) criticize the atemporal character of the model, leading to problems concerning budget constraints or external balances. Furthermore, from a contemporary point of view, the model is not micro-founded and thus - some would argue - of minor (normative) explanatory power owing to its ad-hocery tendencies.
Mundell’s second major work is devoted to the question of whether or not a single country should aspire to enter a monetary union.
A major stimulus for his theory was the signing of the Treaties of Rome in 1957, which led to his 1961 article “A theory of optimum currency areas”.If a country has the choice to join a monetary union, it has to compare the advantage of lower transaction costs with the disadvantage of forgoing its monetary sovereignty. Theoretically you could ask whether it is more favourable to go for several different currencies - in the extreme, one currency for each good which implies a barter economy - or to go for a single currency, leading to only one large integrated monetary area.
In his original version, Mundell singles out labour mobility as the most important criterion. He shows that not country borders, but economic regions matter for a successful optimum currency area. If these are not congruent, a system of flexible exchange rates is superior, at least if no labour mobility is given. Thus from a stability point of view, small regions would be more desirable, while from a transaction cost view, large areas would be favoured.
The model is quite restrictive in terms of expectations, does not elaborate on the tradeoff between prices and employment and assumes a homogeneous stock of labour quality. Since then, Mundell’s ideas have been developed in different directions. There have been several works focusing on issues such as capital mobility, inflation rate and business cycle synchronization and the political will for an integrated currency area. Mundell himself has developed his idea further in his two 1973 papers.
Mundell’s theory played an important role during the preparing debates on the European Monetary Union (EMU). Incidentally his work was honoured the same year as EMU was brought into existence. However, the criteria used to select the participating countries were different from those suggested by Mundell. There have been attempts to promote a modern theory of optimal currency areas, suited to the apparent success of EMU in its first decade (Tavlas 1993; Mongelli 2008; Beetsma and Giuliodori 2010).
Mundell’s arguments were often used to criticize the EMU project and to propose a flexible-exchange-rate solution owing to the heterogeneous structure of the European economies. In spite of various drawbacks and the non-optimality of Europe as assessed against his own standards, Mundell has always emphasized the political component in this process and is to this day a promoter of EMU.Mundell’s ideas seem to be novel and unconventional, on the one hand, and standard, on the other. In his Nobel Prize lecture, he condemned economic policy norms of the gold standard. “Had the price of gold been raised in the late 1920s, or, alternatively, had the major central banks pursued policies of price stability instead of adhering to the gold standard, there would have been no Great Depression, no Nazi revolution, and no World War II” (Mundell 1999: 230). However, later he advocated a return of the USA to the gold standard and a resurrection of a (modified) Bretton Woods system of fixed exchange rates. To his followers this is neither untypical nor inconsistent, it underlines his unorthodox - out of the box - way of thinking.
Oliver Sauter and Peter Spahn
See also:
Balance of payments and exchange rates (III); Open economy macroeconomics (III); Post-Keynesianism (II).
References and further reading
Beetsma, R. and M. Giuliodori (2010), ‘The macroeconomic costs and benefits of the EMU and other monetary unions - an overview of recent research’. Journal of Economic Literature, 48 (3), 603-41.
Frenkel, J.A. and A. Razin (1987), ‘The Mundell-Fleming model a quarter century later’, NBER Working Paper Series No. 2321, National Bureau of Economic Research, Cambridge, MA, pp. 1-87.
Mongelli, F.P. (2008), European Economic and Monetary Integration, and the Optimum Currency Area Theory, Economic Papers No. 302, Brussels: European Commission, Directorate-General for Economic and Financial Affairs.
Mundell, R. (1961), ‘A theory of optimum currency areas’, American Economic Review, 51 (4), 657-65.
Mundell, R. (1963), ‘Capital mobility and stabilization policy under fixed and flexible exchange rates’, Canadian Journal of Economics, 29 (4), 475-85.Mundell, R. (1968), International Economics, New York: Macmillan.
Mundell, R. (1973a), ‘Uncommon arguments for common currencies’, in H.G. Johnson and A.K. Swoboda (eds), The Economics of Common Currencies, London: Allen and Unwin, pp. 114 32.
Mundell, R. (1973b), ‘A plan for a European currency’, in H.G. Johnson and A.K. Swoboda (eds), The Economics of Common Currencies, London: Allen and Unwin, pp. 143-72.
Mundell, R. (1999), ‘A reconsideration of the twentieth century’, The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1999, Prize Lecture, accessed 28 December 2015 at http://www.nobel- prize.org/nobel_prizes/economic-sciences/laureates/1999/mundell-lecture.html.
Obstfeld, M. and K. Rogoff (1995), ‘The intertemporal approach to the current account’, in G.M. Grossman and K. Rogoff (eds), Handbook of International Economics, vol. 3, Amsterdam: Elsevier, pp. 1731-99.
Tavlas, G.S. (1993), ‘The “new” theory of optimum currency areas’, The World Economy, 16 (6), 663-85.