Page 258 - DECO402_Macro Economics

Unit-28: Mundell Model

and recession in the economy. For removing it, interest rate is reduced by KL for increasing money Notes
supply. But at point L, in balance of payment, deficit increase from its previous level. For it still LM
more savings budget will be necessary. For it, it will become necessary that further cut is made in the
interest rates so that recession and unemployment are removed. Like this economy will keep moving
farther from point E and internal and external balance will never happen together. In such situation
allotment rule brings an explosive instability because policies have been coordinated badly.

Did You Know? Allotment rule is of monetary policy for the objective of external balance
and for internal balance is doing of fiscal policy.
In this way in objective of external balance allotment monetary policy and in objective of internal
balance, allotment of fiscal policy must be done. But allotment rule works only when monetary and
fiscal policy without any long lag are continuously and well accommodated, before their impacts
become visual. This is the “Mundell rule” of successful use of monetary and fiscal policy for internal
and external stability, as per which, an instrument must be combined with that target only on which
it has the maximum relative influence. He calls it the Principle of Effective Market Classification.
In reality, Mundell contends for a rational mix of monetary and Fiscal policy. In zone II and IV there is
no disproportion in joint use of monetary and fiscal policy. In zone II both policies must be restrictive
and in zone IV, both policies must be expansive. In rest of the two zones monetary and fiscal policies
must be definitely mixed for achieving both the targets together. According to Mundell, when monetary
policy is combined with objectives of external balance and Fiscal policy is combined with objective of
internal balance, and then both the objectives are met.

Self Assessment

Multiple Choice Questions:
3. In objective of external balance allotment of monetary policy and in objective of internal
balance allotment of ............. must be done
(a) Fiscal policy (b) Money
(c) Principles (d) None of these
4. In reality, Mundel ............... for a rational mix of monetary and Fiscal policy
(a) sophistry (b) contends
(c) meaning (d) none of these
5. Monetary-Fiscal mixture is not a true adjustment ..............
(a) Mechanism (b) Payment
(b) Policy (d) Capital
6. When interest rate is increased by the medium of monetary policy then it brings ............. in
domestic investment.
(a) decline (b) increase
(c) stability (d) none of these

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