Does the Mundell-Fleming Model Apply to Australia’s Economy?

Applying an extended Mundell-Fleming Model to Australia, this paper finds that expansionary fiscal policy does not affect output whereas expansionary monetary policy raises output. In addition, a higher real stock price, a lower real oil price or a lower expected inflation rate would increase output. Hence, the predictions of the Mundell-Fleming model works for Australia’s economy.


Introduction
The Mundell-Fleming model has been studied extensively. Under a floating exchange rate system, it predicts that expansionary fiscal policy does not raise output but causes real appreciation and that expansionary monetary policy raises output and causes real depreciation. Under a fixed exchange rate system, expansionary fiscal policy raises output whereas expansionary monetary policy has no effect on output. Because Australia is classified as an independently floating exchange rate regime and has relatively free capital mobility, it would be an ideal country to examine the impacts of expansionary fiscal policy and monetary policy on output.
This paper focuses on whether the Mundell-Fleming model may apply to Australia's output and has several different aspects. First, the Mundell-Fleming model as presented by Mankiw (2019) is extended to include the real stock price as a proxy for the value of financial assets, which tends to affect consumption spending and the demand for money. Second, a theoretical model is developed to discuss potential impacts of expansionary fiscal and monetary policy on equilibrium output. Third, an advanced econometric methodology is employed in empirical work so that potential residual problems can be corrected. Siklos (1988) employed the Mundell-Fleming model to investigate whether there would be a positive relation between government deficits, interest rates, and trade deficits in Canada. The conventional view in the Mundell-Fleming model is that more government deficits lead to higher interest rates, currency appreciation, less exports, and more trade deficits. Based on the quarterly or annual data, he found that there is no positive relation between interest rates and trade deficits.

Literature Survey
Applying the IS-LM-Phillips curve model, Gali (1992) used money supply, money demand, IS and supply shocks to explain changes in output, prices, interest rates and money in the U.S. The results matched well with the predictions of the IS-LM model. Supply shocks contributed to a large proportion of output fluctuations in the short run.
Employing the SVAR model, Moreno (1992) examined macroeconomic shocks and business cycles in Australia and showed several major findings. Demand shocks raised aggregate output temporarily and prices permanently. Supply shocks played the more important role in the longer run. Technology shocks dominated supply shocks, raised aggregate output, and reduced prices. Shocks to crude oil prices and the supply of labor played smaller roles. Huh (1999) applied the Mundell-Fleming model to study Australia's economy using five variables -IS, money demand, money supply, the world interest rate, and aggregate supply. His results are consistent with the predictions of the Mundell-Fleming model. Expansionary monetary policy results in a permanent depreciation and a temporary increase in output. An increase in IS or money demand leads to appreciation whereas a higher world interest rate results in depreciation.
Based on a sample of 44 countries including Australia, Ilzetzki, Mendoza, and Vé gh (2010) revealed that the effect of fiscal expansion depends on the exchange rate regime, government debt, trade openness, and the development stage. The fiscal multiplier is zero under a floating exchange rate but relatively large under a predetermined exchange rate. The fiscal multiplier is negative in countries with a high level of debt. The fiscal multiplier is greater in closed economies than in open economies. The effect of fiscal expansion is greater in industrialized countries than in developing countries.
Using a sample of 61 countries including Australia and using the panel data technique including the fixed effect and the random effect, Karras (2011) found that the estimated long-run fiscal multiplier ranges from 1.21 to 1.53 in the full sample, from 1.44 to 2.43 for countries with fixed exchange rates, and from 0. study the impacts of capital inflows on 19 emerging markets including six Asian countries. They showed that bond inflows are contractionary due to currency appreciation whereas non-bond inflows also causes currency appreciation but reduce borrowing cost and are expansionary. Different policy tools need to be used in combination in response to different types of inflows.

The Model
Suppose that aggregate expenditures are determined by real income, government tax revenues, government spending, the real interest rate, the real exchange rate, and the real stock price, that the demand for money is affected by the nominal interest rate, real income, and the real stock price, and that the inflation rate is a function of the expected inflation rate, the output gap, the real oil price and the real exchange rate. Extending Mankiw (2019), we can express the IS*, LM* and the augmented short-run aggregate supply functions as: = ( + , , ) = ( , − * , , ) Suppose that potential real GDP is constant in the short run. Solving for Y, and simultaneously, we derive equilibrium real GDP as: The Jacobian for the three endogenous variables can be written as: The effect of government budget deficit on equilibrium real GDP can be expressed as: The impact of real money supply on equilibrium real GDP is given by An increase in the real stock price is expected to increase or reduce equilibrium real GDP depending upon whether the financial stock is treated as wealth or a substitute for real money balances (Hsing, 2007): These analyses suggest that expansionary monetary policy is expected to increase equilibrium real GDP, that expansionary fiscal policy is expected not to affect equilibrium real GDP, and that the impact of a higher real stock price is unclear.

Empirical Results
The The DF-GLS test on the residual is applied to detect if there would be any cointegration among these time series variables. The value of the test statistic is estimated to be -2.1142 compared with the critical value of -1.9468. Hence, these variables are cointegrated and have a stable long-term relation. Table 1 reports the estimated regression. The GARCH model is employed in empirical work to correct for autoregressive conditional heteroscedasticity. Approximately 98.6% of the variation in real GDP can be explained by the six right-hand side variables. The positive coefficient of the deficit-to-GDP ratio is insignificant at the 10% level. The coefficients of other variables are significant at the 1% level.
Real GDP has a positive relation with real M2 money and the real stock price and a negative relation with the real interest rate, the real oil price and the expected inflation rate. The findings that expansionary fiscal policy does not affect real GDP whereas expansionary monetary policy has a positive impact on real GDP suggest that the predictions of the Mundell-Fleming model are correct.
The positive significant coefficient of the real stock price implies that the substitution effect dominates the wealth effect in the money demand function. Note that the real exchange rate is not included in the LM * function (Mankiw, 2019), suggesting that the demand for money is not affected by the real exchange rate. There may be potential substitution effect between real money demand and the real exchange rate. As the Australian dollar depreciates versus the U.S. dollar or other major currencies, people may substitute the U.S. dollar or other major currencies for the Australian dollar in order to reduce the cost of exchange for the U.S. dollar or engage in currency trading to make a profit in the future.
Potential future research may apply the IS-MP-AS model (Romer, 2000(Romer, , 2006 to examine the impacts of expansionary fiscal and monetary policies on real GDP. The advantage of this model is the incorporation of the monetary policy reaction function and inflation targeting to replace the LM * function. Empirical results would determine which model would work better for Australia.