In the earlier decades, the world’s economy was mainly involved in foreign trade but was nonetheless insulated from external pressures. On the other hand, the modern day economies are highly open with goods and capital markets open to the many forces of international competition (Obstfeld 2001).
With open economies, governments have to maintain a stable exchange rate with growing capital flows and monetary policies that are oriented toward internal goals. Stable exchange rates keep inflation down. Capital flows are important for enhancing growth and development especially in developing countries. Therefore, monetary policy control is essential for macroeconomic adjustments (Kamar and Bakardzhieva 2003).
It would be ideal to have these three running smoothly but sadly, we cannot achieve all of these objectives simultaneously. This is what has been termed as a trilemma, the unholy trinity, irreconcilable trinity or inconsistent trinity. This trilemma influences the exchange rate policy to implement in developing countries.
Developing countries like the Sultanate of Brunei have decided to have a fixed exchange rate regime while others like the Kingdom of Bhutan have a relatively flexible regime that is kept within limits of fluctuations against the Indian rupee. As a result of excess savings in Asia, there has been an abundance of global liquidity in the world economy and this has resulted in reduced interest rates.
These outcomes have resulted in the current account deficits in both Bhutan and Brunei governments. This is a common phenomenon often observed where capital flows from capital-scarce developing countries to capital–rich developed economies (International Labour Organization 2010). It partly explains the deficits but these current account imbalances can best be explained using the Mundell –Fleming model.
The Mundell-Fleming theory was created by Robert Mundell and Marcus Fleming. They individually came up with a model that could be applied to an open economy. Previous models applied to closed economies using the IS-LM model. Mundell and Fleming extended the IS-LM to form the IS-LM-BP. BP stands for balance of payments which represents the foreign market (IFOM).
The IS-LM-BP model shows different combinations of interest rates and income that are compatible with equilibrium in the balance of payments (Fratianni and Hagen 1997).
The Mundell-Fleming theory analyses the effectiveness of fiscal and monetary policies for small countries under fixed and flexible exchange rates with the assumptions of perfect capital mobility. With perfect or near perfect capital mobility, the balance of payments (BoP) is at equilibrium at the world interest rates (Fan and Fan 2002).
Capital mobility determines the balance of payments according to the Mundell-Fleming model. When capital is perfectly immobile internationally, a rise in domestic interest rates above the world interest rates would not attract capital inflows.
When capital is perfectly mobile, a slight rise in domestic rates above the world interest rates would attract a massive capital inflow. Capital is considered to be imperfectly mobile and in fixed exchange rate regimes, it is important only in determining the speed at which the economy returns to its initial position (Fratianni and Hagen 1997).
World interest rates affect domestic rates in both fixed and flexible exchange rate systems. The fall in the world interest rates trigger a balance of payments surplus. It causes an inflow of capital thus increasing demand for domestic currency.
For fixed rate regimes, the central bank has to get involved in order to keep the exchange rate fixed. To bring the exchange rate equal to the global rate, the central bank increases money supply. This results to current account deficits (Calvo 1996).
The fixed exchange regime has contributed to the current deficits. Fixed exchange rates are not sustainable with increasing globalization (Kamar and Bakardzhieva 2003). Many small countries choose pegged exchange rate systems because of lack of securities markets and financial institutions that can execute monetary policy. This leaves them with fiscal policy as their only option.
In the Mundell and Fleming theory, when a small country maintains a fixed exchange rate, in the presence of perfect capital mobility, money stocks become endogenous eliminating monetary policy from the list of possible stabilization policy tools (Fan and Fan 2002).
Current account imbalances exist because a fixed exchange rate can only be maintained by running down reserves. According to the Mundell-Fleming model the balance of payments moves into deficit due to expansion of money supply (Van den Berg 2010). The increase in income causes the current account to move into deficit while the fall in the interest rate causes the capital account to go into deficit.
When these two occur, the monetary authorities purchase the domestic currency with reserves. They continue to reduce the money supply with those purchases until the domestic rate matches with the world interest rate (Fratianni and Hagen 1997).
Fiscal policies play a role in the existence of current account deficits. Brunei has registered current account deficits due to the inability of the government to control the situation. In open economies, governments often add a balance of payments indicator, such as the current account balance as an additional policy target.
This current account is controlled by the level of the exchange rate (Hasan and Isgut 2009) Brunei is a small economy with a fixed exchange rate system. The Mundell-Fleming theory argues that a small economy that is open to financial capital flows cannot simultaneously control the level of the exchange rate and monetary policy tools such as money supply and the interest rates (Hasan and Isgut 2009).
A country such as Brunei is open to financial capital flows. It is able to control the exchange rate but according to this theory, it cannot do so while still controlling the money supply. This theory explains the deficits in their current accounts.
The interest rates of the world can have an adverse effect on the current account of small economies. Lowering of the world interest rates has led to the current account deficits in Brunei and Bhutan. According to the Mundell-Fleming theory, if the domestic interest rates adjust to an increased demand for funds, this attracts foreign capital inflows which subsequently depress current account balances.
Increase in government net lending has also been cited as a factor that may adversely affect current accounts. If the domestic interest rate is fully fixed in international markets, then an increase in government net lending raises domestic absorption without strengthening the growth of exports (International Labour Organization 2010).
The social environment of any economy can lead to imbalances. The Mundell-Fleming theory attributes deficits in current accounts to social protection. Social security spending may lead to current account imbalances.
When protection mechanisms are increased or new ones developed, households reduce their precautionary savings. Social protection systems might also target disposable income from low income earners who are less likely to be saving leading to an increase in domestic absorption (International Labour Organization 2010).
The current account deficit is affected by the domestic output. According to the Mundell-Fleming theory, the current account balance is a direct function of the level of domestic output, the exchange rate and a negative function of foreign income.
If all other things do not change the higher the domestic output, the smaller the current account balances (Boughton 2001). Large deficits cause indebtedness by borrowing internally and externally. The current account balance can be corrected by use of good fiscal policies (Hakro 2009).
This paper has discussed small countries’ decision to choose the fixed exchange rate system despite its many disadvantages. It has then discussed the current account deficits in Brunei and Bhutan using the Mundell-Fleming theory. This theory is an extension of the IS-LM where it adds a balance of payments curve to cater for open economies.
It explains that in an open economy it would not be possible to maintain a fixed exchange rate while having capital inflows and monetary policy control. With a fixed exchange rate, the monetary authorities are always matching the domestic interest rate to the world interest rates. When world interest rates fall, the domestic interest rate has to fall.
This dropping of domestic interest rates is achieved by buying the domestic currency with reserves resulting in a current account deficit. The Mundell-Fleming theory has also blamed fiscal policies and social protection for the current account deficits.
Small economies like Brunei and Bhutan may not have the right financial institutions in place to rely on monetary policy and they have resorted to fiscal policies. A change in fiscal policies would be a solution to the problem faced by these countries.
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