Chapter 3

Mundell – Fleming model and AD

in an open economy

Hồ Thị Hoài Thương

Email: [email protected]

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 In this chapter, you will learn

▪ The Mundell-Fleming model

▪ Policy effects in the Mundell-Fleming model
▪ Impacts of changes in interest rates
▪ Fixed vs floating exchange rates

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 1. Mundell- Fleming Model

1.1 Assumptions
▪ An extended IS –LM model for a small, open economy
with perfect capital mobility
▪ Perfect capital mobility: the economy can borrow or
lend as much as it wants in world financial markets,
and therefore, the economy’s interest rate is
controlled by the world interest rate, mathematically
denoted as r = r*.
▪ It takes the price level as given and then shows what
causes fluctuations in income and the exchange rate.

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 1.2 The IS* curve and the goods
market

IS* equation:
IS* curve is drawn with e
given r*.
Slope of IS* curve:

IS*
Y

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 1.3 The LM* curve and the money
market

LM* equation:
e LM*
LM* curve is drawn with
given r*.
Slope of LM* curve:

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1.4 Equilibrium in the Mundell- Fleming
Model

e LM*

Equilibrium
exchange
rate

IS*
Equilibrium Y
income

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 2. Policy effects in the Mundell-
Fleming model

2.1 Policy effects under floating exchange

rates
▪ In a system of floating exchange rates,
e is allowed to fluctuate in response to changing
economic conditions.

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 a. Fiscal policy under floating
exchange rates
At any given value of e,
a fiscal expansion
e LM 1*
increases ......
shifting IS* to the ...... e2

Results: e1
e ....., Y..... IS 2*
IS 1*
Y
Y1

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 Lessons about fiscal policy

▪ In a small open economy with perfect capital

mobility, fiscal policy cannot affect out put.
▪ “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.

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 b. Monetary policy under floating
exchange rates

An increase in M
shifts LM*........... e LM 1*LM 2*

Results:
e........, Y ..........
e1
e2
IS 1*
Y
Y1 Y2

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 Lessons about monetary policy
▪ In a small open economy with perfect capital mobility,
fiscal policy can affect output.
▪ Monetary policy affects output by affecting
the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M  e  NX  Y

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 c. Trade policy under floating
exchange rates

At any given value of e,

a tariff or quota reduces e LM 1*
imports, increases ......., e2
and shifts IS* to the .........
e1
Results:
IS 2*
e ..........., Y............
IS 1*
Y
Y1

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 Lessons about trade policy

▪ In a small open economy with perfect capital

mobility, trade policy cannot affect output.
▪ Trade policy (import restrictions)
▪ Reduces exports due to the exchange rate
appreciation

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 2.2 Policy effects under 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.

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 a. Fiscal policy under fixed exchange
rates
Under floating rates,
a fiscal expansion
e LM 1*LM 2*
would .... e.
To keep e from ......,
the central bank must
...... domestic currency, e1
which .......... M IS 2*
and shifts LM* ......
IS 1*
Results: Y
Y1 Y2
e ........., Y ............
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 b. Monetary policy under fixed
exchange rates

An increase in M would
shift LM* ...... and reduce....
e LM 1*LM 2*
To prevent the ...... in e,
the central bank must
...... domestic currency,
which ....... M and shifts e1
LM* .......

Results: IS 1*
Y
e ..........., Y ........... Y1

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 c. Trade policy under fixed exchange
rates
A restriction on imports
puts ............ pressure on e.
e LM 1*LM 2*
To keep e from .........,
the central bank must
..... domestic currency,
which ....... M e1
and shifts LM* ...... IS 2*
Results: IS 1*
Y
e ............, Y .......... Y1 Y2

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 Summary of policy effects in the
Mundell-Fleming model
Monetary policy Fiscal policy Trade policy

Fixed exchange
rate

Flexible
exchange rate

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 Exercise 1

Consider the following information about Macroland

economy: C = 100+0.8Y; I= 400-20r; G=500,; r*= 4;
NX=60-50e; MD= 2Y+1000-200r; MS = 18000; P=2.
a, Find the equilibrium level of e and Y
b, If government spending increases to 520, what is the
new equilibrium Y? what is the new equilibrium e?
c, If money supply increases to 18200, what is the new
equilibrium Y? what is the new equilibrium e?

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 A few points: Mundell - Fleming
Model under Y –r coordinates
▪ Equilibrium in the Mundell- Fleming Model under Y –r
coordinates
✓The balance of
payments (BP) is the
sum of the current
account and the capital
account
✓We assume perfect
capital mobility, so BP
curve is horizontal
✓ Equilibrium point is the
intersection among IS,
LM and BP which
indicate internal balance
in goods and money
market and external
balance in foreign
exchange market
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 A few points: the Mundell Fleming Model
under Y –r coordinates
▪ Fiscal policy with flexible exchange rate
r
 IS shifts to the right
LM ⚫ The Central Bank doesn’t have
to react: The interest rate
increases and the exchange
rate appreciates
BP  The appreciation of the
r*
exchange rate penalises
exports and stimulates imports
⚫ IS shifts left

IS
 Policy is ineffective
Y

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 A few points: the Mundell Fleming Model
under Y –r coordinates
▪ Monetary policy with flexible exchange rate:
r
 LM shifts to the right
LM ⚫ The interest rate falls, which
leads to a depreciation of the
exchange rate e

 The depreciation of the

BP exchange rate stimulates
r*
exports and penalises imports
⚫ As a resut IS shifts to the right

IS
 Policy is effective
Y

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 A few points: the Mundell Fleming Model
under Y –r coordinates
▪ Fiscal policy with flexible exchange rate:
r
 IS shifts to the right
LM ⚫ The Central Bank doesn’t have
to react: The interest rate
increases and the exchange
rate appreciates
BP  The appreciation of the
r*
exchange rate penalises
exports and stimulates imports
⚫ IS shifts left

IS
 Policy is ineffective
Y

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 A few points: the Mundell Fleming Model
under Y –r coordinates
▪ Fiscal policy with fixed exchange rate:
r
 IS shifts to the right:
LM ⚫ The crowding out effect
increases the rate of interest,
creating appreciation pressures
on e
BP  In order to guarantee the fixed
r* exchange rate the CB must
immediately reduce r to r=r* by
increasing money supply

IS
 Policy is effective in
Y increasing Y

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 A few points: the Mundell Fleming
Model under Y –r coordinates
▪ Monetary policy with fixed exchange rate:
r  LM shifts to the right
LM ⚫ The increase in the money
supply lowers the rate of
interest, leading to depreciation
pressures on e

BP
ir  In order to guarantee the fixed
exchange rate the CB must
immediately increase r to r=r*
by reducing money supply

IS
 Such a policy cannot be
Y carried out in practice

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 3. Impacts of changes in
interest rates
▪Two reasons why r may differ from r*
▪ country risk: The risk that the country’s
borrowers will default on their loan repayments
because of political or economic turmoil.
Lenders require a higher interest rate to
compensate them for this risk.
▪ expected exchange rate changes: If a country’s
exchange rate is expected to fall, then its borrowers
must pay a higher interest rate to compensate
lenders for the expected currency depreciation.

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 3. Impacts of changes in interest
rates
r = r *+ 
where  (Greek letter “theta”) is a risk premium,
assumed exogenous.
Substitute the expression for r into the
IS* and LM* equations:

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 3. Impacts of changes in interest
rates
The effects of an increase
in : IS* shifts .....,
because e LM 1*LM 2*
  .....r  .....I
LM* shifts ......, because e1
  ......r  ....MD
so Y must rise to restore
money market eq’m. e2 IS 1*
Results: IS 2*
Y
e ....., Y ......... Y1 Y2

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 4. 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.

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 CASE STUDY: 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
A nation must choose (U.S.) (Hong Kong)
one side of this
triangle and
give up the Independent Fixed
opposite Option 3 exchange
monetary
(China) rate
corner. policy

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The Chinese Currency Controversy

▪ 1995-2005: China fixed its exchange rate at 8.28

yuan per dollar, and restricted capital flows.
▪ Many observers believed that the yuan was
significantly undervalued, as China was
accumulating large dollar reserves.
▪ U.S. producers complained that China’s cheap
yuan gave Chinese producers an unfair advantage.
▪ President Bush asked China to let its currency float;
Others in the U.S. wanted tariffs on Chinese goods.
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CASE STUDY:
The Chinese Currency Controversy

▪ If China lets the yuan float, it may indeed

appreciate.
▪ However, if China also allows greater capital
mobility, then Chinese citizens may start moving
their savings abroad.
▪ Such capital outflows could cause the yuan to
depreciate rather than appreciate.

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