A Graphical Demonstration of Fiscal and Monetary Policy with Flexible Prices

MUNDELL'S article on "The Appropriate Use of Monetary and Fiscal Policy" filled a gap left by Meade's balance of trade approach. For the latter, either fiscal or monetary policy could be used to affect the level of income and, concomitantly, the level of imports and the trade balance. An expansionary policy leads to a deterioration of the trade balance, and consequently yields an overall improvement only when unemployment is accompanied by a surplus in the foreign account. A contractionary policy improves the balance of trade and serves internal and external balance only when an economy has inflation and a surplus in the external account. The analysis requires a trade-off between internal and external balance in economies with inflation and a surplus or, on the other hand, unemployment and a deficit. In order to correct imbalances in both sectors a policy instrument must be attached to each goal. By introducing capital flows responsive to interest rate differentials, Mundell was able to show that the balance of payments would be responsive primarily to monetary policy, leaving fiscal policy to deal with the level of national income.