The Chinese University of Hong Kong

Department of Economics

GLEF3010
International Monetary Systems
2024-2025 (First Term)

Lecture 6: Open Economy Macroeconomics : The Mundell-Fleming Model

Wallace K C Mok
Open Economy Macroeconomics
Mundell Fleming Model
The Model Exchange Rate Extensions
Regimes
 The Mundell-Fleming model
• How to analyze the small Open Economy in
the Short Run when prices are sticky?

• We develop the Mundell-Fleming Model,

which is the ISLM model for the analysis of
the open economy.
 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 domestic currency
 The IS* curve: Goods market Equilibrium
Y  C (Y  T )  I (r *)  G  NX (e )

The IS* curve is e

drawn for a given
value of r*.
Intuition for the slope:
IS*
 e   NX   Y
Y
 The LM* curve:
Money market Equilibrium
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 Y

demand with supply,

regardless of e.
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
Open Economy Macroeconomics
Mundell Fleming Model
The Model Exchange Rate Extensions
Regimes
 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
 Fiscal Policy under Floating
Exchange Rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y ) e LM1*
At any given value of e, e2
a fiscal expansion
increases Y, e1
shifting IS* to the right. IS 2*
IS1*
Y
Results: Y1
e > 0, Y = 0
 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.
 Monetary Policy under Floating
Exchange Rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM1*LM 2*
An increase in M
shifts LM* right
because Y must rise e1
to restore equilibrium in e2
the money market. IS1*
Y
Results: Y1 Y2
e < 0, Y > 0
 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 monetary policy does not raise

world aggregate 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.
Trade Policy under Floating Exchange Rates
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
e LM1*
At any given value of e,
e2
a tariff or quota reduces
imports, increases NX, e1
and shifts IS* to the IS 2*
right. IS1*
Y
Results: Y1
e > 0, Y = 0
 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.”
 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.
 Fiscal policy under Fixed Exchange Rates

Under floating rates,

fiscal policy is ineffective
e LM1*LM 2*
at changing output.
Under fixed rates,
fiscal policy is very effective
e1
at changing output.
IS 2*
Under floating rates, a fiscal IS1*
expansion would raise e. Y
Y1 Y2
Results:
e = 0, Y > 0
Monetary Policy under Fixed Exchange Rates

An increase
Under in Mrates,
floating would
monetary
shift policy
LM* right andis reduce e
To prevent the fall LM1*LM 2*
very
e. effective at in e,
changing
the central output.
bank must
buy domestic
Under currency,
fixed rates,
e1
monetary
which policy
reduces cannot
M and
be used
shifts LM* to back
affectleft.
output.
IS1*
Y
Results: Y1
e = 0, Y = 0
 Trade policy under Fixed Exchange
Rates
Under floating rates,
A restriction on imports
import restrictions
puts upward pressure on e
do not affect Y or NX. LM1*LM 2*
To keep e from
e.
Under fixed rates, import
rising,
restrictions increase Y and
the central bank must
NX. e1
sell domestic IS 2*
But, these gains come at the
currency,
expense IS1*
Results:of other countries:
which
the increases
policy merely M shifts Y
e = 0, Y > 0 Y1 Y2
and shifts
demand LM*
from right.to
foreign
domestic goods.
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
Monetary
   0 0 0
expansion
Import restriction 0  0  0 
Open Economy Macroeconomics
Mundell Fleming Model
The Model Exchange Rate Extensions
Regimes
 Interest-rate differentials
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.
Differentials in the Mundell-Fleming Model
r  r * 
where  (Greek letter “theta”) is a risk
premium, assumed exogenous.
Substitute the expression for r into the
IS* and LM* equations:

Y  C (Y  T )  I (r *   )  G  NX (e )

M P  L (r *   ,Y )
 The effects of an increase in 
IS* shifts left, because
  r  I e LM1*LM 2*
LM* shifts right, because
e1
  r  (M/P)d,
so Y must rise to restore
money market eq’m. e2 IS1*
Results: IS 2*
Y
e < 0, Y > 0 Y1 Y2
 The effects of an increase in 
• The fall in e is intuitive:
An increase in country risk or an expected
depreciation makes holding the country’s
currency less attractive.
Note: an expected depreciation is a
self-fulfilling prophecy.
• The increase in Y occurs because
the boost in NX (from the depreciation)
is greater than the fall in I (from the rise in r).
 Why Income might not Rise
• The central bank may try to prevent the
depreciation by reducing the money supply.

• The depreciation might boost the price of

imports enough to increase the price level
(which would reduce the real money supply).
• Consumers might respond to the increased risk
by holding more money.
Each of the above would shift LM* leftward.
 Mundell-Fleming and the AD curve
• So far in Mundell-Fleming model, P has been
fixed. Next: to derive the AD curve, consider the
impact of a change in P in the Mundell-Fleming
model. We now write the equations as:

(IS* ) Y  C (Y  T )  I (r *)  G  NX (ε )

(LM* ) M P  L (r *,Y )

(Earlier in this chapter, P was fixed, so we

could write NX as a function of e instead of .)
 Deriving the AD curve
 LM*(P2) LM*(P1)
Why AD curve has 2
negative slope: 1
P  IS*
(M/P)
Y2 Y1 Y
P
 LM shifts
left P2
  P1
 NX AD
 Y Y2 Y1 Y
 From the short run to the long run
 LM*(P1) LM*(P2)
If Y1  Y ,
then there is 1
2
downward pressure
on prices. IS*
Over time, P will Y1 Y Y
P LRAS
move down, causing
P1 SRAS1
(M/P )
P2 SRAS2

AD
NX  Y
Y1 Y
Y
 Large: Between small and closed
• Many countries – including the U.S. – are neither closed nor
small open economies.
• A large open economy is between the polar cases of closed &
small open. It will have some influence over r*.

• Consider a fiscal expansion in a flexible exchange rate regime:

– Like in a closed economy,
G > 0   r  Y
– Like in a small open economy,
G > 0     NX and no change in Y
– The result for the large open economy is somewhere in between these
two cases since appreciation of the exchange rate will depress net
exports, but no need to have r = r*
 Large: Between small and closed
Closed Economy Small Open Economy
r e LM*
LM

IS2 IS*2
IS1 IS*1
Y Y

r
LM
Since the large open
economy can have influence
over r*, the level of net
exports crowding out is not
as large as in the case of the
small open economy. IS2
IS1 IS3 Large Open Economy
Y