19

Mundell-Fleming Model:
IS-LM Model for the Small Open
Economy

Biswa Swarup Misra

 The Mundell-Fleming model

▪ Key assumption:
Small open economy with perfect capital
mobility.
r = r*
▪ Goods market equilibrium – the IS* curve:
Y = C (Y −T ) + I (r *) + G + NX (e )
where
e = nominal exchange rate
= foreign currency per unit of domestic
currency
Session-19 Mundell-Fleming Model B.S. Misra
Slide 1
 The nominal exchange rate
e = nominal exchange rate,
The number of units of foreign currency that one unit of
domestic currency can buy(number of dollars per unit of
rupee)

Some textbooks and newspapers define the exchange rate as the

reciprocal of the one here (e.g., rupees per dollar instead of dollars
per rupee).

The one here is easier to use, because a rise in “e” corresponds to

an “appreciation” of the country’s currency. Using the reciprocal
would mean that a rise in “e” is a depreciation, which seems counter-
intuitive.

A country’s “e” is simply the price (measured in foreign currency) of a

unit of that country’s currency.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 2
 Derivation of the IS* Curve
in a small open economy

Session-19 Mundell-Fleming Model B.S. Misra

Slide 3
 The IS* curve: Goods market eq’m
Y = C (Y −T ) + I (r *) + G + NX (e )

The IS* curve is drawn e

for a given value of r*.
Intuition for the slope:

 e   NX   Y

IS*
Y

Session-19 Mundell-Fleming Model B.S. Misra

Slide 4
 Derivation of the LM* Curve

Session-19 Mundell-Fleming Model B.S. Misra

Slide 5
 The LM* curve: Money market eq’m
M P = L (r *,Y )
The LM* curve
e LM*
▪ is drawn for a given
value of r*.
▪ is vertical because:
given r*, there is
only one value of Y
that equates money
demand with supply, Y
regardless of e.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 6
 Equilibrium in the Mundell-Fleming
model
Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L (r *,Y )
e LM*

equilibrium
exchange
rate

IS*
equilibrium Y
level of
income
Session-19 Mundell-Fleming Model B.S. Misra
Slide 7
 Floating & fixed exchange rates

▪ In a system of floating exchange rates,

e is allowed to fluctuate in response to changing
economic conditions.
▪ In contrast, under fixed exchange rates,
the central bank trades domestic for foreign
currency at a predetermined price.
▪ Next, policy analysis –
▪ first, in a floating exchange rate system
▪ then, in a fixed exchange rate system
Session-19 Mundell-Fleming Model B.S. Misra
Slide 8
 Fiscal policy under floating exchange
rates
Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L (r *,Y )
e LM 1*
At any given value of e,
e2
a fiscal expansion
increases Y, e1
shifting IS* to the right.
IS 2*
Results:
IS 1*
e > 0, Y = 0 Y
Y1

Session-19 Mundell-Fleming Model B.S. Misra

Slide 9
 How fiscal policy works
▪ Closed Economy- fiscal expansion puts upward pressure on
the country’s interest rate.
▪ In a small open economy with perfect capital mobility, as soon
as the domestic interest rate rises, capital will flow in to take
advantage of the rate difference.
▪ Capital inflows cause an increase in foreign demand for
rupees in the foreign exchange market, causing the rupee to
appreciate.
▪ This appreciation makes exports more expensive to
foreigners, and imports cheaper to people at home, and thus
causes NX to fall. The fall in NX offsets the effect of the fiscal
expansion.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 10
How fiscal policy works
▪ How do we know that Y = 0?
▪ Because maintaining equilibrium in the money market
requires that Y be unchanged: the fiscal expansion does
not affect either the real money supply (M/P) or the world
interest rate (because this economy is “small”).
▪ Hence, any change in income would throw the money
market out of whack.
▪ Because r=r*and M P = L (r *,Y ) there
is only one level of Y
that can satisfy the equilibrium in the money market.
▪ So, the exchange rate has to rise until NX has fallen
enough to perfectly offset the expansionary impact of the
fiscal policy on output.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 11
 Lessons about fiscal policy
▪ In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
▪ “Crowding out”
▪ closed economy:
Fiscal policy crowds out investment by causing
the interest rate to rise.
▪ small open economy:
Fiscal policy crowds out net exports by causing
the exchange rate to appreciate.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 12
Monetary policy under floating
exchange rates
▪ M increases Rightward LM* shift:
▪ Intuition - At the initial (r*,Y), an increase in M
throws the money market out of whack.
▪ To restore equilibrium, either Y must rise or the
interest rate must fall, or some combination of
the two.
▪ In a small open economy, though, the interest
rate cannot fall. So Y must rise to restore
equilibrium in the money market.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 13
 Monetary policy under floating exchange
rates
Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L (r *,Y )
e LM 1*LM 2*
An increase in M
shifts LM* right
because Y must rise
to restore eq’m in e1
the money market. e2
Results: IS 1*
Y
e < 0, Y > 0 Y1 Y2

Session-19 Mundell-Fleming Model B.S. Misra

Slide 14
 How Monetary Policy Works
▪ Initially, the increase in the money supply puts
downward pressure on the interest rate. (In a
closed economy, the interest rate would fall.)
▪ Because the economy is small and open, when
the interest rate tries to fall below r*, savers send
their loanable funds to the world financial
market.
▪ This capital outflow causes the exchange rate to
fall, which causes NX --- and hence Y --- to
increase.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 15
Lessons About Monetary Policy
▪ Monetary policy affects output by affecting
the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX 
Y

▪ Expansionary mon. policy does not raise world

agg. demand, it merely shifts demand from
foreign to domestic products.
So, the increases in domestic income and
employment are at the expense of losses abroad.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 16
 Trade policy under floating exchange
rates
Y = C (Y −T ) + I (r *) + G + NX (e )
M P = L (r *,Y )
e LM 1*
At any given value of e,
a tariff or quota reduces e2
imports, increases NX,
and shifts IS* to the right. e1
IS 2*
Results:
IS 1*
e > 0, Y = 0 Y
Y1

Session-19 Mundell-Fleming Model B.S. Misra

Slide 17
 How Trade Policy Works
▪ At the initial exchange rate, the tariff or quota
shifts domestic residents’ demand from foreign
to domestic goods.
▪ The reduction in their demand for foreign goods
causes a corresponding reduction in the supply
of the country’s currency in the foreign exchange
market.
▪ This causes the exchange rate to rise.
▪ The appreciation reduces NX, offsetting the
import restriction’s initial expansion of NX.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 18
How Trade Policy Works
▪ How do we know that the effect of the
appreciation on NX exactly cancels out the effect
of the import restriction on NX?
▪ There is only one value of Y that allows the
money market to clear;
▪ Further, because Y, C, I, and G are all
unchanged, NX = Y-(C+I+G) must also be
unchanged.
▪ So policy objective to increase NX has not been
successful
Session-19 Mundell-Fleming Model B.S. Misra
Slide 19
Lessons about trade policy

▪ Import restrictions cannot reduce a trade deficit.

▪ Even though NX is unchanged, there is less
trade:
▪ the trade restriction reduces imports.
▪ the exchange rate appreciation reduces
exports.
▪ Less trade means fewer “gains from trade.”

Session-19 Mundell-Fleming Model B.S. Misra

Slide 20
Lessons about trade policy, cont.
▪ Import restrictions on specific products save jobs
in the domestic industries that produce those
products, but destroy jobs in export-producing
sectors.
▪ Hence, import restrictions fail to increase total
employment.
▪ Also, import restrictions create “sectoral shifts”, a
shift in demand from export-producing sectors to
import-competing sectors, which cause frictional
unemployment.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 21
Fixed exchange rates
▪ Under fixed exchange rates, the central bank stands
ready to buy or sell the domestic currency for foreign
currency at a predetermined rate.
▪ In the Mundell-Fleming model, the central bank shifts the
LM* curve as required to keep e at its preannounced
rate.
▪ This system fixes the nominal exchange rate.
In the long run, when prices are flexible,
the real exchange rate can move even if the nominal rate
is fixed.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 22
 Mechanism of Fixed Exchange Rate
▪ Under fixed exchange rates, the central bank stands ready to buy
or sell the domestic currency for foreign currency at a
predetermined rate.
▪ Let RBI announce a fixed exchange rate of Rs. 50=1$ or Rs.
1=$0.02
▪ The RBI will be committed to give Rs. 1 in exchange of $0.02 or to
give $0.02 in exchange for Rs. 1
▪ To carry out this policy RBI must have purchased enough dollars.
▪ Essence of a fixed exchange rate policy is the commitment of the
central bank to alter money supply to adjust to whatever level that
will ensure that equilibrium exchange rate in the market equals
that of the announced exchange rate. As long as the central bank
stands ready to buy or sell foreign currency at the announced
exchange rate, the money supply will adjust to the necessary
level.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 23
 Adjustment Mechanism in Fixed Exchange Rate System
Exchange Rate Rs. $ Rs. $ Correction Mechanism
E Some one can buy $1 by paying Rs. 40 in
q the market and sell the one dollar to RBI
Market u and receive Rs. 50 and making a profit of
40 1 1 0.0250
(Appreciated) i Rs. 10. This causes money supply in the
v economy to rise and the rupee to
a depriciate
l The central bank is committed to buy and
Fixed 50 1 1 0.0200
e sell $ at the fixed exchange rate
n Some one can buy $1 by paying Rs. 50 to
t RBI and sell the $1 in the market for Rs. 60
Market
60 1 1 0.0167 and making a profit of Rs. 10. This causes
(Depriciated)
T money supply in the economy to decline
o and the rupee to appreciate
Session-19 Mundell-Fleming Model B.S. Misra
Slide 24
 Fiscal policy under fixed exchange
rates
Under
Underfloating
floatingrates,
rates,
afiscal
fiscalpolicy
expansion
is ineffective
e LM 1*LM 2*
would raise e.output.
at changing
To keepfixed
Under e from rising,
rates,
the central
fiscal bank
policy must
is very
sell domestic currency, e1
effective at changing
which
output.increases M IS 2*
and shifts LM* right.
IS 1*
Results: Y
Y1 Y2
e = 0, Y > 0
Session-19 Mundell-Fleming Model B.S. Misra
Slide 25
Fiscal policy under fixed exchange
rates
▪ When IS curve shifts, there is upward pressure
on the exchange rate.
▪ Because the central bank is committed to fixed
exchange rate, arbitrageurs quickly respond by
selling foreign currency to the central bank an
din the process increasing money supply.
▪ The increase in money supply shifts the LM
curve to the right.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 26
 Monetary policy under fixed
exchange rates
An increase
Under in Mrates,
floating would
monetary
shift policy
LM* right andisreduce e.
very effective at e LM 1*LM 2*
To prevent the fall in e,
changing
the central output.
bank must
buy
Underdomestic currency,
fixed rates,
which reduces
monetary M and
policy cannot e1
shifts LM*toback
be used left.output.
affect
Results: IS 1*
Y
e = 0, Y = 0 Y1

Session-19 Mundell-Fleming Model B.S. Misra

Slide 27
Monetary policy under fixed
exchange rates
▪ The monetary expansion puts downward pressure on the
exchange rate. To prevent it from falling, the central
bank starts buying domestic currency in greater
quantities to “prop up” the value of the currency in
foreign exchange markets. This buying removes
domestic currency from circulation, causing the money
supply to fall, which shifts the LM* curve back.
▪ Another way of looking at it: To keep the exchange rate
fixed, the central bank must use monetary policy to shift
LM* as required so that the intersection of LM* and IS*
always occurs at the desired exchange rate. Unless the
IS* curve shifts right (an experiment we are not
considering now), the central bank simply cannot
increase the money supply.
Session-19 Mundell-Fleming Model B.S. Misra
Slide 28
 Trade policy under fixed exchange
rates
Under floating rates,
A restriction on imports puts
import restrictions
upward pressure on e.
do not affect Y or NX. e LM 1*LM 2*
To keep
Under e from
fixed rates,rising,
the central
import bank must
restrictions
sell domestic
increase Y andcurrency,
NX.
which increases M e1
But, these gains come
atand
theshifts LM*ofright.
expense other IS 2*
countries:
Results: the policy IS 1*
merely Y
eshifts
= 0, demand
Y > 0 from Y1 Y2
foreign to domestic goods.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 29
 Summary of policy effects in the
Mundell-Fleming model

type of exchange rate regime:

floating fixed
impact on:

Policy Y e NX Y e NX

fiscal expansion 0    0 0

mon. expansion    0 0 0

import restriction 0  0  0 

Session-19 Mundell-Fleming Model B.S. Misra

Slide 30
 Floating vs. fixed exchange rates

Argument for floating rates:

▪ allows monetary policy to be used to pursue other
goals (stable growth, low inflation).

Arguments for fixed rates:

▪ avoids uncertainty and volatility, making
international transactions easier.
▪ disciplines monetary policy to prevent excessive
money growth & hyperinflation.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 31
 The Impossible Trinity

A nation cannot have free

capital flows, independent Free capital
monetary policy, and a flows
fixed exchange rate
simultaneously. Option 1 Option 2
(U.S.) (Hong Kong)
A nation must choose
one side of this
triangle and
give up the Independent Fixed
Option 3 exchange
monetary
opposite (China)
policy rate
corner.

Session-19 Mundell-Fleming Model B.S. Misra

Slide 32
 Session Summary

1. Mundell-Fleming model
▪ the IS-LM model for a small open economy.
▪ takes P as given.
▪ can show how policies and shocks affect income
and the exchange rate.
2. Fiscal policy
▪ affects income under fixed exchange rates, but not
under floating exchange rates.

slide 33
 Session Summary

3. Monetary policy
▪ affects income under floating exchange rates.
▪ under fixed exchange rates, monetary policy is not
available to affect output.
4. Fixed vs. floating exchange rates
▪ Under floating rates, monetary policy is available for
can purposes other than maintaining exchange rate
stability.
▪ Fixed exchange rates reduce some of the
uncertainty in international transactions.

slide 34