Model still has currency for central bankers

Economists have been trying for hundreds of years to explain how markets work. They have long believed that, even though market economies appear wild and disorderly, there must be some kind of order to it all.

The earliest economists certainly thought so. Adam Smith, David Ricardo and Thomas Malthus all built little models of an "economy" that tried to show what they thought were the fundamental economic phenomena glueing things together. And their practice of model-building still continues.

But when you look at the history of the development of economic theory, you see that some models have proved remarkably insightful, yielding knowledge about the world that has genuinely helped to push things forward. Other models, on the other hand, have been far less helpful.

Take this little example.

In 1836, a British economist called Nassau Senior travelled to Manchester, in England's north-west, to see what effect the Factory Act was having on the local cotton industry.

The act was controversial among manufacturers because it required them to take better care of children in their charge. It made it illegal, for instance, for children aged between nine and 13 to work more than eight hours a day in a factory. Children under nine were not allowed to work at all.

On top of this, while it was still legal for older teenagers to labour for long periods, for 11½ hours a day on average, six days a week, a popular political movement - comprising church groups, reformist MPs and workers - was agitating to have those hours reduced to 10 a day. The politics of the time were shifting in favour of workers.

Senior's sympathies were with the manufacturers. In his report of his tour of Manchester, he told authorities that "the manufacturer is tired of regulations - what he asks is tranquillity - implora pace". He also took time away from his tour to write a letter to the president of the Board of Trade, warning him that, if the length of the working day was reduced to 10 hours, it would be "utterly ruinous" for the industry.

How did he know this? Well, according to his micro-economic model, all profits in the cotton industry were made in the last hour of an 11½-hour working day, so if the length of the day was reduced to 10 hours then all profits would be "destroyed".

History has shown that his model was absurd. But not all are as crude as Senior's. Some have proved useful and enduring.

The assistant governor of the Reserve Bank of Australia, Guy Debelle, gave a speech last week in defence of one of these latter models. This model was developed in the early 1960s and it is named after the economists on whose work it is based, Robert Mundell and Marcus Fleming. It is called the Mundell-Fleming model. It provides the framework for thinking about global monetary policy.

The Mundell-Fleming model was developed at a time when most developed economies were still operating under an international regime of fixed exchange rates and tight capital controls.

The two economists wanted to know what would happen to a small economy with fixed exchange rates if financial capital was allowed to move freely across borders.

Their model demonstrated that if capital was perfectly mobile, a small open economy would not be able to maintain fixed exchange rates and an independent monetary policy.

Instead, policymakers would have to choose between fixed exchange rates or independent monetary policy. You cannot achieve all three policy goals at once.

This is known as the "impossible trinity".

It led to a powerful insight: a floating exchange rate will act as an economic stabiliser, rising and falling to match economic "fundamentals" such as the terms of trade. If you allow your exchange rate to float, it will free up your monetary policy to be used for other goals (such as inflation targeting).

This insight helped to convince a generation of policymakers that they ought to switch to floating exchange rates (which Australia did in the early 1980s, more than 20 years later).

Debelle said this model was still the "long-time stalwart" that policymakers return to when thinking about issues involving a floating exchange rate. He then discussed one of these issues facing Australia at the moment.

"When the exchange rate is moving in line with the terms of trade, the real fundamentals, it plays the appropriate macro stabilisation role," he said. "In Australia's case, over the 30 years of the float, the exchange rate has done just that most of the time."

But problems emerge with floating exchange rates when financial factors cause the rate to deviate from an economy's real fundamentals.

That is exactly what Australia has been dealing with recently, as the US pursues an "extremely expansionary" monetary policy.

The policy has spilled over to the rest of the world and countries like Australia have experienced an exchange rate appreciation as capital flows have gone in search of higher yields.

"But, in Australia's case, an exchange rate appreciation that is not in line with the fundamentals, if persistent enough, can lead to Dutch disease," Debelle said.

And what may happen if that capital flow reversed suddenly? "In Australia's case, the exchange rate depreciates and the main concern is inflation."

But Debelle says both of these situations are theoretically manageable if a country has an appropriate macro framework, such as an inflation targeting regime.

All of these insights come from the Mundell-Fleming model. It has been 50 years since the model was developed and its theoretical offspring are far more sophisticated and complex. But, after half a century of improvements and additions, Debelle says it still provides the best intuition for central bankers.

You may learn more advanced technologies at graduate school "but then you go out into the real world of policymaking and your first and best intuition still comes from Mundell-Fleming". Not a bad for a little model.

Ross Gittins is on leave.