1) The Mundell-Fleming model examines the effects of fiscal and monetary policy in open economies under different exchange rate regimes. 2) Under floating exchange rates, fiscal policy has no effect on output as currency appreciation offsets demand changes, while monetary policy is powerful by changing the exchange rate. 3) Under fixed exchange rates, fiscal policy can boost output as the exchange rate is held constant, but monetary policy has no effect as the money supply adjusts to maintain the fixed rate.

1. Chapter Twelve 1
CHAPTER 13
The Open Economy Revisited:
The Mundell-Fleming Model
and the Exchange-Rate Regime
Daw Chan Myae July
17.07.21

2. Chapter Twelve 2
Introducing…
e
Income, output, Y
LM*
IS*
Equilibrium
exchange rate
Equilibrium income
This model is a close relative of the IS-LM model; both stress the
interaction between the goods market and the money market. Price levels
are fixed, and both show short-run fluctuations in aggregate income. The
Mundell-Fleming Model assumes an open economy in which trade and
finance are added; the IS-LM assumes a closed economy.
Chapter 13

3. Chapter Twelve 3
This model, often described as “the dominant policy paradigm for
studying open-economy monetary and fiscal policy,” makes one
important and extreme assumption: the economy being studied is a
small open economy and there is perfect capital mobility, meaning
that it 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*.
One key lesson about this model is that the behavior of an economy
depends on the exchange rate regime it adopts—floating or fixed.
This model will help answer the question of which exchange rate
regime should a nation adopt?
Chapter 13

4. Chapter Twelve 4
Under a system of floating exchange rates, the exchange rate is set
by market forces and is allowed to fluctuate in response to changing
economic conditions.
The exchange rate e, adjusts to achieve simultaneous equilibrium in
the goods market and the money market. When something changes
that equilibrium, the exchange rate is allowed to adjust to a new
rate.
Chapter 13

5. Chapter Twelve 5
Assumption 1:
The domestic interest rate is equal to the world interest rate (r = r*).
Assumption 2:
The price level is exogenously fixed since the model is used to analyze
the short run (P). This implies that the nominal exchange rate is
proportional to the real exchange rate.
Assumption 3:
The money supply is also set exogenously by the central bank (M).
Assumption 4:
Our LM* curve will be vertical because the exchange rate does not enter
into our LM* equation.
IS*: Y = C(Y-T) + I(r*) + G + NX(e)
Let’s start with two equations (notice the asterisk next to IS and LM to
remind us that the equations hold the interest rate constant):
The Small Open Economy Under Floating Exchange Rates
LM*: M/P = L (r*,Y)

6. Chapter Twelve 6
The IS* curve slopes downward because a higher exchange rate
reduces net exports (since a currency appreciation makes domestic
goods more expensive to foreigners), which in turn, lowers
aggregate income.
Income, output, Y
IS*
Exchange rate, e
Chapter 13

7. Chapter Twelve 7
Expenditure,
E
Income, output, Y
Y=E
Planned expenditure,
E = C + I + G + NX
Exchange
rate,
e
Income, output, Y
Exchange
rate,
e,
Net exports, NX
NX(e) IS*
An increase in the exchange
rate, lowers net exports,
which shifts planned
expenditure downward and
lowers income. The IS*
curve summarizes these
changes in the goods market
equilibrium.
(a) (c)
(b)

8. Chapter Twelve 8
The LM curve and
the world interest
rate together determine
the level of income.
The LM* curve is
vertical because the
exchange rate does
not enter into the LM*
equation.
Recall the LM* equation is:
M/P = L (r*,Y)
Interest
rate,
r
Income, output, Y
LM
Exchange
rate,
e
Income, output, Y
LM*
r = r*

9. Chapter Twelve 9
e
Income, output, Y
LM*
IS*
e
Income, output, Y
LM*
IS*
IS*'
LM*'
When income rises in a small open economy, due to
the fiscal expansion, the interest rate tries to rise but
capital inflows from abroad put downward pressure
on the interest rate. This inflow causes an increase in
the demand for the currency pushing up its value
and thus making domestic goods more expensive
to foreigners (causing a –DNX). The –DNX offsets
the expansionary fiscal policy and the effect on Y.
When the increase in the money supply puts downward
pressure on the domestic interest rate, capital flows out
as investors seek a higher return elsewhere. The capital
outflow prevents the interest rate from falling. The
outflow also causes the exchange rate to depreciate,
making domestic goods less expensive relative to
foreign goods, and stimulates NX. Hence, monetary
policy influences the e rather than r.
+DG, or –DT 
+De, no DY
+DM 
-De, +DY

10. Chapter Twelve 10
Fixed Exchange Rates
Under a fixed exchange rate, the central bank announces a value
for the exchange rate and stands ready to buy and sell the domestic
currency at a predetermined price to keep the exchange
rate at its announced level. Fixed exchange rates require a commitment
of a central bank to allow the money supply to adjust to whatever level
will ensure that the equilibrium exchange rate in the market for foreign-
currency exchange equals the announced exchange rate.
Most recently, China fixed the value of its currency against the U.S.
dollar, which has resulted in a lot of tension between the two nations.
It is important to realize that this exchange-rate system fixes the
nominal exchange rate. Whether it fixes the real exchange rate depends
on the time horizon.
Chapter 13

11. Chapter Twelve 11
e
Income, output, Y
LM*
IS*
e
Income, output, Y
LM*
IS*
IS*'
A fiscal expansion shifts IS* to the right. To maintain
the fixed exchange rate, the Fed must increase the
money supply, thus increasing LM* to the right.
Unlike the case with flexible exchange rates, there is no
crowding out effect on NX due to a higher exchange
rate.
If the Fed tried to increase the money supply by
buying bonds from the public, that would put down-
ward pressure on the interest rate. Arbitragers respond
by selling the domestic currency to the central bank,
causing the money supply and the LM curve
to contract to their initial positions.
+DG, or –DT + DY
LM*'
+DM  no DY
The Mundell-Fleming Model
Under Fixed Exchange Rates

12. Chapter Twelve 12
Fixed vs.
Exchange Rate Conclusions
Fixed Exchange Rates Floating Exchange Rates
• Fiscal Policy is Powerful.
• Monetary Policy is Powerless.
• Fiscal Policy is Powerless.
• Monetary Policy is Powerful.
The Mundell-Fleming model shows that fiscal policy does not influence
aggregate income under floating exchange rates. A fiscal expansion
causes the currency to appreciate, reducing net exports and offsetting
the usual expansionary impact on aggregate demand.
The Mundell-Fleming model shows that monetary policy does not
influence aggregate income under fixed exchange rates. Any attempt
to expand the money supply is futile, because the money supply
must adjust to ensure that the exchange rate stays at its announced level.
Hint: (Think of “floating” money.)
Hint: (“Fixed” and “Fiscal” sound alike).

13. Chapter Twelve 13
Policy in the Mundell-Fleming Model:
A Summary
The Mundell-Fleming model shows that the effect of almost any
economic policy on a small open economy depends on whether the
exchange rate is floating or fixed.
The Mundell-Fleming model shows that the power of monetary and
fiscal policy to influence aggregate demand depends on the exchange
rate regime.
Chapter 13

14. Chapter Twelve 14
A country with fixed exchange rates can, however, conduct
a type of monetary policy by deciding to change the level at
which the exchange rate is fixed.
A reduction in the official value of the currency is called a
devaluation, and an increase in the value is called a revaluation.
Chapter 13

15. Chapter Twelve 15
1) Allows monetary policy to be used
for other purposes such as stabilizing
employment or prices.
1) Monetary policy is committed
to the single goal of maintaining
the announced level.
2) May lead to greater volatility in
income and employment.
1) Exchange-rate volatility
creates uncertainty and
makes trade more difficult.
2) Tempers overuse of
monetary authority.
1) More speculation and
volatility expected.
Chapter 13

16. Chapter Twelve 16
IS*: Y=C(Y-T) + I(r*) + G + NX(e)
LM*: M/P=L (r*,Y)
Recall the two equations of the Mundell-Fleming model:
e
Income, output,Y
LM*
IS*
LM*'
P
Income, output,Y
AD
When the price level falls, the LM*
curve shifts to the right. The
equilibrium level of income rises.
The second graph displays the
negative relationship between P and
Y, which is summarized by the
aggregate demand curve.
Chapter 13

17. Chapter Twelve 17
Real
exchange
rate
Income, output,Y
LM*
IS*
LM*'
P
Income, output,Y
AD
SRAS2
SRAS1
K
C
P1
P2
e1
e2
Point K in both panels
shows the equilibrium
under the Keynesian
assumption that prices are
fixed at P1. Point C in both
diagrams shows the equilibrium
under the classical assumption
that the price level adjusts to
maintain income at its natural level
Y.
K
C
Chapter 13

18. Chapter Twelve 18
18
Mundell-Fleming Model
Floating exchange rates
Fixed exchange rates
Devaluation
Revaluation
Chapter 13

19. Chapter Twelve 19
Mundell-Fleming Model
Floating exchange rates
Fixed exchange rates
Devaluation
Revaluation