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Subject ADVANCED MACROECONOMICS

Paper No and Title 6: Advanced Macroeconomics

Module No and Title 6: Mundell Fleming Model

Module Tag ECO_P6_M6

ECONOMICS PAPER No. 6: Advanced Macroeconomics

MODULE No. 6: Mundell Fleming Model
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Definitions used
3.1 Small open economy
3.2 Flexible exchange rate
3.3 Fixed exchange rate
3.4 Monetary policy
3.5 Fiscal policy
4. Mundell Fleming model
4.1 Introduction
4.2 Assumptions
4.3 The Model
4.4 The Effect of Expansionary Fiscal Policy under Floating Exchange
Rate
4.5 The Effect of Expansionary Fiscal Policy under Fixed Exchange
Rate
4.6 The Effect of Monetary Policy under Floating Exchange Rate
4.7 The Effect of Monetary Policy under Flexible Exchange Rate
5. Summary

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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1. Learning Outcomes
After studying this module you shall be able to
 Learn about the Mundell Fleming model
 Understand the effect of fiscal and monetary policy under floating and fixed
exchange rate

2. Introduction
As the globalization has occurred the countries are open to trade with each other, it is
important to study the open economy model viz, the Mundell Fleming Model. This model
is an extension of IS-LM model. Also, we can clearly see the effects of different policies
under different regimes. For this model, Robert Mundell was awarded Nobel Prize for his
work.

3. Definition Used
3.1 Small Open Economy - It is an economy that participates in international trade, but is
small enough when compared to its trading partners. Because of this its policies do not
influence the world prices, interest rates, or incomes.
3.2 Fixed Exchange Rate- It is the exchange rate that is fixed by the central bank of the
country.
3.3 Flexible Exchange Rate- It is the exchange rate that is determined via the market
forces i.e. by demand and supply of currency in the foreign exchange market. It is llowed
to change in response to the changing economic conditions.
3.4 Monetary Policy- It is the policy by which the money supply is controlled in the
economy.
3.5 Fiscal Policy - It is the policy by which the taxes and the government expenditure is
controlled in the economy by the government.

4. The Model
4.1 Introduction

In this section we present the Mundell- Fleming Model. It is an open economy version of
the IS - LM model. Being similar to the IS-LM model, it focusses on the interaction
between the goods market and the money market. Also, like the IS-LM model, it explains
the short run fluctuations in the aggregate income and analyze the effects of monetary
and fiscal policy on the economy.
The assumptions of this model are:
A.1: The economy under consideration is a small open economy.
ECONOMICS PAPER No. 6: Advanced Macroeconomics
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A.2: There is perfect capital mobility in this small economy, that is, the economy can
borrow or lend as much as it wants in the world financial market. The economy’s interest
rates determined by the world interest rate (r*). It works in the following fashion: let
there be a rise in the rate of interest (r) in the small economy (due to some event in the
economy). It would then attract foreigners to start lending to this small economy for
example: by buying this country’s bonds. This will lead to the capital inflow in the
economy, which would continue to occur till the rate of interest, r, reduces; then the
capital outflow would occur to earn a higher return abroad. This would continue till r is
equal to r* in the world financial market i.e. r = r*.

A.3: The price level in this small economy (P) is equal to world’s price level (P*). Hence,
P = P*. This implies that the real exchange rate is proportional to the nominal exchange
rate.

As in the IS-LM model, we derive the goods market and money market equilibrium
schedules. The only difference is the addition of the open economy terms in the IS and
the LM curves. We call them IS* and LM* curves and finally we find out the
simultaneous equilibrium in the economy.

4.2 The Model

Let r be the rate of interest in our small open economy and r* be the rate of interest in the
world financial markets. Then, r=r* because of assumption A.1.

 Derivation of IS* curve

The usual IS curve for closed economy is modified into IS* curve for the open economy
by adding net exports and r*. That is,

IS*: Y = C (Y-T) + I (r*) + G + NX (e) … (1)

Equation (1) states that aggregate income is the sum of consumption (C), investment (I),
government expenditure (G) and net exports (NX).
The IS* is derived from the net exports schedule and the Keynesian cross.

Consider figure 1 and Panel A, which shows the net exports schedule. It is a downward
sloping curve which shows the relationship between net exports and the exchange rate in
the economy. Suppose, the exchange rate appreciates, i.e. there is an increase in exchange
rate from E1 to E2. Thus, the foreign goods become cheaper relative to domestic goods.
Thus the exports decrease and imports increase which leads to decrease in net exports
from NX1 to NX2. This shows that net exports curve is downward sloping for this
economy.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Now, consider Panel B which shows the usual Keynesian cross. Using Panel A and Panel
B, we derive the IS* curve in Panel C. Consider an increase in exchange rate from e 1 to
e2, it lowers the net exports from NX1 to NX2. This leads to shifts the planed expenditure
schedule downward from AS1 to AS2 which reduces income from Y1 to Y2. Thus we have
the two points A and B. Joining these we obtain the IS* in Panel C shows the IS* curve.

Figure 1: Derivation of IS*

Panel A

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Panel B

Panel C

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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 Derivation of the LM* curve

The LM* curve for open economy is derived as follows:

The usual LM curve is given by the equation: M/P = L(r, y)

Since r = r*, the LM* curve becomes: M/P = L(r*, y)

Diagrammatically, the LM* is derived as follows:

The LM* curve is derived using the LM curve. Consider figure 2 and Panel A. It shows
the upward sloping, usual LM curve. As r = r* point E becomes the relevant point in the
LM*. Panel B shows LM* curve which is a straight line vertical curve measuring
exchange rate on the y-axis and income level on the x-axis. This is so because the
exchange rate does not enter into LM*. The money supply M is an exogenous variable
and the price level P is assumed to be exogenous. Thus, given the world interest rate, r*,
and the LM* schedule, determines the aggregate income.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Figure 2: Derivation of LM*

Panel A

Panel B

 Simultaneous determination of equilibrium

Using the above IS* and LM* we have equilibrium for the open economy:
We know,
IS*: Y = C (Y-T) + I (r*) + G + NX (e)
M*: M/P = L(r*, y)
There are two endogenous variables – Y and e in the model and the policy variables are
G,T,M,P and r*. The simultaneous equilibrium occurs at the point of intersection of IS*
and LM*. It shows the equilibrium E and Y* at which the goods market and the money
market clear.
The diagrammatic representation is represented in Figure 3.

Figure 3: Open Economy Equilibrium

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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4.4 Effect of Policies

This section discusses effect of the monetary policy and fiscal policy under the fixed
exchange rate regime and flexible exchange rate regime.

4.5 Fiscal Policy and Its Impact under Flexible Exchange Rate System

Consider Figure 4, the economy is at equilibrium at point E1. The rate of exchange is e1
and the level of income is Y1. Let, there be an expansionary fiscal policy. It leads to a rise
in the government expenditure or a fall in the taxes. Now, this has stimulative effect on
the aggregate demand in the economy and due to which IS* curve will shift to the right
i.e. IS*1 and IS*2 as shown by the figure 4. The new equilibrium occurs at point E2. At
this point, the exchange rate increases from e1 to e2. However, the level of income
remains at Y1.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Figure 4

An important question emerges that - why the income level remains same in contrast to
the closed economy. In the closed economy, when expansionary policy occurs, the
aggregate demand increases which includes the demand for money also. This increase in
demand for money leads to a rise in the rate of interest in the economy. But, this is not
possible in a small open economy because as soon as domestic rate of interest rises above
the world interest rate, the capital flows in from abroad which pushes the domestic rate
back to world interest rate. Hence, fiscal policy under flexible exchange rate is
ineffective.

4.6 Fiscal Policy and Its Impact under Fixed Exchange Rate

Fixed exchange rate system is a system in which the central bank fixes the value for the
purchase and sale of domestic currency. Consider Figure 5. In this figure we measure
exchange rate on the vertical axis and income on the horizontal axis. Initial equilibrium
occurs at point E1 where the IS*1 curve and LM*1 curve intersect. Suppose, the exchange
rate is fixed at e1. This is, let us say, higher than the equilibrium exchange rate. This is
higher than the equilibrium exchange rate, then the arbitrageurs will buy the foreign
currency in the foreign exchange market and sell the same to the central bank and earn a
profit. This will lead to an increase in money supply, that is, LM* curve will shift to the
right to LM*2. This will result in a decline in the equilibrium exchange rate.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Suppose, there is an expansionary fiscal policy in the domestic economy then, either
government expenditure will increase or taxes will decrease to stimulate the domestic
spending. Due to which IS* curve will shift to the right. The initial equilibrium occurs at
E1. A shift in the IS1* to IS2* curve disturbs the equilibrium level since there is fixed
exchange rate the bank must increase money supply, that is the LM1* curve shifts to
LM2* curve. Which leads to new equilibrium at point E2. The point E2 is associated with
an income level Y2 which is higher than the previous level Y1. However, the exchange
rate is fixed. Thus, under fixed exchange rate system, a fiscal expansion raises income
level in the economy. This is in contrast to the fiscal expansion under flexible exchange
rate system.

Figure 5

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4.7 Effect of Monetary Policy under Flexible Exchange Rate

Under monetary policy the central bank of the country increases the money supply.
Consider Figure 6, the economy is initially in equilibrium at point E1 where the rate of
exchange is e1 and the income level is Y1.
Suppose the government follows an expansionary monetary policy then LM1* curve will
shift to LM2* curve, due to increase in money supply. This results in the new equilibrium
which occurs at E2. The point E2 is associated with rise in the income level from Y1 to Y2
and the exchange rate decreases from e1 to e2. Here the monetary policy influences
income level by changing the exchange rate. The transmission mechanism is different
here. An increase in the money supply puts a downward pressure on the domestic interest
rate. This results in movement of capital to foreign countries. However, since it is a small
open economy, this prevents the domestic rate of interest from falling below the world
rate of interest. Also another effect operates due to capital outflow – that is, the capital
outflow increases the supply of domestic currency in the market for foreign exchange
which causes the domestic currency to depreciate in value, making domestic goods
cheaper relative to foreign goods, thus stimulating net exports. Thus, here the monetary
policy influences income by changing the exchange rate rather than the rate of interest.

Thus, the transmission mechanism in the open economy is different than that of the
closed economy.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Figure 6

Thus, the monetary policy is fully effective under the flexible exchange rate system.

4.8 Effect of Monetary Policy under Fixed Exchange Rate

As stated in earlier section, the monetary policy implies an increase or decrease in money
supply. Consider the figure 7, here, the economy is in equilibrium at point E1 – where IS*
and LM* curves are intersecting. The rate of exchange is e1 and the level of income is Y1.
Suppose an expansionary monetary policy is followed, this results in shifting LM1* to
LM2*. The new equilibrium occurs at point E2. This is associated with an increase in
income level and a decline in the exchange rate. But, the exchange rate is fixed already
by the central bank, the arbitrageurs will sell the domestic currency to the central bank.
This leads to a decrease in the money supply of the domestic currency in the market
which causes LM2* to return to the initial level. The income level and the exchange rate
level remains the same even after an expansionary monetary policy. Thus, the monetary
policy is totally ineffective in the fixed exchange rate.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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Figure 7

ECONOMICS PAPER No. 6: Advanced Macroeconomics

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5. Summary
5. Summary
In this module, we discussed the Mundell-Fleming model for a small open economy. It is
an open economy version of the IS - LM model. Being similar to the IS-LM model, the
model focusses on the interaction between the goods market and the money market. Also,
like the IS-LM model, it explains the short run fluctuations in the aggregate income and
analyze the effects of monetary and fiscal policy on the economy. The IS-LM curves
were derived for the small open economy and equilibrium in the domestic country was
determined. Further the monetary and the fiscal policies were discussed. The fiscal policy
was found to effective in fixed as well as in flexible exchange rate, whereas the monetary
policy was found to be effective only in the flexible exchange rate system.

ECONOMICS PAPER No. 6: Advanced Macroeconomics

MODULE No. 6: Mundell Fleming Model