Page 221 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 19 : Expenditure Reducing and Expenditure Switching Policies

The Mundellian Policy Assignment Notes
Mundell suggested in 1962 and again in 1968 a solution to the problem of policy predicament discussed
in the preceding section. We discuss here briefly the Mundellian approach to the problem of policy
assignment. According to Tinbergen rule, a policy instrument should be assigned a target which it can hit
relatively most effectively. Going by this rule, monetary policy or fiscal policy should be assigned a task
which it can perform most successfully in achieving internal and external balance. Since monetary
and fiscal policies have both their relative advantages and disadvantages, these policies need to be so
combined that their positive effects are maximized and negative effects minimized.
Mundell’s rule of policy assignment for the four different kinds of economic problems in four zones
are summarized as follows :

Zone Nature of Imbalance Monetary Policy Fiscal Policy
I Unemployment and BOP surplus Expansionary Expansionary
II Inflation and BOP surplus Expansionary Contractionary
III Inflation and BOP deficit Contractionary Contractionary
IV Unemployment and BOP deficit Contractionary Expansionary

However, Mundellian solution has its own problems. These policy assignment rules offer a stable
solution to the problem of internal and external balance only when (i) policies are chosen judiciously
and implemented without discretionary changes, and (ii) there is no time lag in the working of
monetary and fiscal policies. These are big conditions, particularly, the condition regarding the time
lag. Therefore, Mundell’s solution is considered to be unstable and, therefore, impractible.

Mundell developed a principle of effective market classification and suggested a rule for efficacy
and stability of policy measures following Tinbergen’s rule.

Problems in Applying Mundellian Monetary-Fiscal Policy Mix
The monetary-fiscal policy-mix as a means to attaining internal and external balance has strong
theoretical underpinning. In reality, however, this approach has serious practical problems.
One, the Mundellian approach assumes that policy-makers are fully aware of (i) the internal balance
path (i.e., IB schedule), (ii) the external balance path (i.e., the EB schedule), (iii) the zone in which the
economy is placed, and (iv) how away is the economy placed from the IB schedule. In reality, however,
these parameters are unknown and difficult to determine.
Two, for lack of necessary data, determination of an exact combination of monetary and fiscal measures
compatible with one another for achieving internal and external balance is an extremely difficult
task. Therefore, some arbitrariness has to be there in the policy formulation. Besides, political
considerations do affect the decision-making. Any mismatch between the monetary-fiscal mix on
these accounts affects the efficacy of the policy mix.
Three, the monetary-fiscal mix is based on some predictable relationship between the interest rate and
capital flows. This relationship may be disturbed after the implementation of the policy for some non-
economic factors, e.g., political uncertainty, labour unions, war, etc. For example, India was facing a double
digit inflation—11.25 percent in June-July 2008. The GOI was in dilemma as to what mix of monetary and
fiscal policies to adopt. Only interest rate was marginally raised, which had not proved to be effective.
Four, the Mundellian approach does not provide a ‘true adjustment mechanism’. This approach
considers capital flows as autonomous, whereas, in reality, a considerable part of capital flows is
accommodating, not autonomous. The accommodating capital flows are not affected by the change
in the interest rate. This condition may seriously affect the efficacy of Mundell’s solution.

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