A somewhat basic overview of the workings behind the Mundell-Fleming model under both flexible and fixed exchange rates.

1. Mundell-Fleming
Model
Paul Kohlhaussen

2. Agenda
• History
• IS-LM
• Balance of Payments
• The Impossible Trinity
• Applications
• Further points of investigation

3. Assumptions
History
Mundell’s & Fleming’s Expansion
• 1960s
• Robert Mundell
• Marcus Fleming
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Independently expanded
on the Keynesian model of
macroeconomic policy
• Small open economy, short run
• Impact of macroeconomic policy under
• Floating exchange rates
• Fixed exchange rates

4. IS-LM
Investment Savings Curve
Liquidity Preference
Money Supply Curve
• IV: Interest Rate
• DV: Level of Y
• IV: Level of Y
• DV: Interest Rate
Y = C + I + G + NX M/P = L(i,Y)
i
I
= Y
MD
= i
Y

5. Balance of Payments
Current + Capital Accounts:
A country’s transactions with the rest of the world
BoP = CA + KA
Current Account
Capital Account
• Imports & exports
• Investment income
• Foreign aid - transfers
• ± Foreign holdings of
country’s assets
• ± Country’s holdings of
foreign assets

7. Under a Flexible Exchange Rate
Global interest
rates increase:
i
Y
IS
LM
BoP
BoP1
IS1
• Capital flows out
• Depreciates currency
• Boosts exports
• IS curve shifts to the right
(Marshall-Lerner condition)}
iW
iW1
Y1Y

8. Under a Fixed Exchange Rate
Expansionary
Monetary Policy:
i
Y
IS
LM
BoP
• Gov. buys bonds: money supply
• i decreases, Y increases = capital outflow
• Y = Imports increase: NX<0: currency depreciates
iW
iW1 BoP1
LM1
Y1Y

9. Under a Fixed Exchange Rate
Expansionary
Fiscal Policy:
• Government expenditure , IS shifts right
• i increases, Y increases = capital inflow
• Current account , BoP shifts up
• Sell currency, money supply = new Y
i
Y
IS
LM
BoP
BoP1
IS1
iW
iW1
Y1Y
LM1

10. The Impossible Trinity
Free capital
mobility
Fixed
exchange
rates
Independent
monetary policy

11. Applications
• Croatia: only monetary or only fiscal
policy will have no effect on economy
because of capital flows (LC!)
• German reunification: i increased
with strong growth, caused France
and Belgium to lose demand & output
due to EMS ties
• Poland? (Too big?)
• Other suggestions?
Aim: to investigate the effectiveness of different
policies under the Mundell-Fleming model
Transition of
socialist
planning to
open capitalism}