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MACROECONOMICS. Chapter 12 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange Rate Regime. Robert Mundell. Home Page:. /. 1999 Nobel Lecture:. The Works of R.A. Mundell:

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Chapter 12

The Open Economy Revisited: The Mundell-Fleming Model and the Exchange Rate Regime

Robert mundell
Robert Mundell

Home Page:

1999 Nobel Lecture:

The Works of R.A. Mundell:

The is curve
The IS* Curve

NX depends on real exchange rate

but if prices are sticky in the short

run both countries will have fixed prices

and NX will depend on nominal exchange


The derivation of

IS* curve from

Keynesian Cross

and behavior of






Observe that IS*

has e instead of r

on the vertical axis.



Small economies
Small Economies

  • Smallness means cannot affect price; in this case, interest rate: r*.

  • Perfect mobility implies any deviation from the r* will instigate capital flows to bring r=r*.

    • r>r* => capital inflow => r down.

    • r<r* => capital outflow => r up.

The lm curve
The LM* Curve



The LM in the upper diagram is derived the

regular way: higher Y shifts money demand

up and with fixed money supply, r has to go up.

But higher r attracts capital inflow and lowers r

back to r*. Capital inflow forces the appreciation

of e and lowering of NX, eliminating the reason

of Y increase. But if money supply were to

increase, then higher Y can be sustained with

constant r.

More on lm and lm
More on LM and LM*



If r=r*, then the interest rate is determined

outside of the country and given as a

constant. That means we will be at a point

on the LM curve. Y will be the level

corresponding to r*. In the new LM* where

the vertical axis is e, money supply will

determine the level of Y but it can come at

any e: vertical LM*.







r* determines Y. If r>r* at the intersection

of IS and LM, capital inflow matches –NX.

The drop in NX shifts IS but it is a movement

along the IS*. Currency appreciates.






Fiscal expansion with floating fx
Fiscal Expansion with Floating FX

Because money supply

is fixed, and income has

to match r* on LM, the expansionary effect of fiscal policy is matched

by the contractionary

effect of lower NX as capital inflow appreciates

the currency.

Refer to slide #6 to see

what is happening to

IS and LM.

Fiscal expansion under floating fx
Fiscal Expansion Under Floating FX



IS increase raises the interest rate.

Capital inflow into the country.

Currency appreciates.

NX starts to fall until interest rate falls

back to r*.




As the IS shifts back because of drop

of NX. But as long as r>r* currency still

appreciates. When IS had shifted all the

way to the original IS, e had risen all the

way to the new intersection of IS* and LM*.


Monetary expansion under floating fx
Monetary Expansion Under Floating FX









When r=r* more money

supply in the system will not

affect the real rate of interest.

So Investments will not change. What will make IS* reach a higher Y? How would you show the effect on IS and LM?

Monetary expansion with floating fx
Monetary Expansion with Floating FX



Money supply increase will depreciate

the currency and by increasing NX raise

the equilibrium Y.


LM shift lowers the interest rate and

causes capital outflow. This results in

an increase of NX. In the IS-LM

diagram, more NX makes IS increase

until r=r*.






Trade restriction under floating exchange rates
Trade Restriction Under Floating Exchange Rates

Trade restriction is a quota on imports or tariff on imports. If the demand for imports is reduced via trade restriction, NX will shift to the right.

What happens to Y, r, e, I, C, NX as a result

of the trade restriction that was put to reduce

the trade deficit (or increase the trade surplus)?

Trade restriction under floating fx
Trade Restriction Under Floating FX



Import tariff or quota will restrict imports. NX

goes up and IS shifts right in both ISLM and




Higher r attracts capital inflow and appreciates

the domestic currency. NX falls.





Fixed exchange rate governs the money supply
Fixed Exchange Rate Governs the Money Supply

Equilibrium e is higher

than what the Central

Bank wants it to be:

$1=€1.50 but the Fed

wants it to be $1= €1.

The Fed enters the FX

market and keeps on

buying euros with dollars.

Money supply increases

until the fixed exchange

rate is reached. Of course,

higher demand for euros

appreciates € and

depreciates $.

How easy is this for CB?

Fixed exchange rate governs the money supply1
Fixed Exchange Rate Governs the Money Supply

If the Central Bank wants

to raise the value of the

currency in the FX

market, it will keep

on buying the domestic

currency with foreign

reserves it has. CB is

withdrawing money from

the economy.

If the long run e is the

equilibrium e, what do

you think will happen in

the long run?

How easy is this for CB?

Fiscal expansion under fixed exchange rates
Fiscal Expansion Under Fixed Exchange Rates

Government spending

increases: at each and

every level of e IS* is

larger. IS* shifts right.

But the new IS* forces e

upwards. The Central

Bank, to keep the FX fixed,

has to buy foreign currency

with the domestic currency.

The money supply

increases and LM* shifts

right. Y increases but e

remains constant.

This result holds for any

change that shifts IS* to

the right.

Fiscal expansion under fixed fx
Fiscal Expansion Under Fixed FX



Fiscal expansion raises the interest rate and

appreciates the currency. However, we are

under fixed exchange rate regime.


In order to bring the currency back, CB will have to put more currency in the FX market by buying foreign currency.




Fixed exchange rates require fixed interest

rates. To keep both e and r constant, the

Fed increases the money supply.



Monetary expansion under fixed exchange rates
Monetary Expansion Under Fixed Exchange Rates

Increasing money

supply shifts LM* to

the right. Exchange

rate (e) tends to fall to

2. To keep e constant,

CB buys domestic

currency with foreign

reserves it has. The

value of domestic

currency in the FX

market goes back to

the fixed e. In the

process, the CB has

removed domestic

currency from

circulation: money

supply down.



Monetary expansion with fixed fx
Monetary Expansion with Fixed FX



Monetary expansion results in lower r

and currency depreciation. To bring the

FX market into the fixed exchange rate,

the central bank has to sell foreign

currency and buy domestic currency.

As the central bank withdraws money

from the economy, interest rate rises

back to the original level, too.







Trade restriction under fixed exchange rates
Trade Restriction Under Fixed Exchange Rates

Can you explain why

LM* is shifting to the


Red IS* and Blue LM*

intersects at a higher e

than the fixed e the CB

wants. CB buys foreign

currency with the

domestic currency.

The amount of currency

outstanding increases:

money supply up.

Same as slide # 17.


During a severe recession (depression) what policy action would be effective to

improve the GDP under floating and fixed FX regimes?

Monetary policy is ineffective under fixed fx rules
Monetary Policy is Ineffective Under Fixed FX Rules would be effective to

  • How can a government make monetary policy effective under fixed exchange rate regime?

    • By devaluing the currency and benefiting from the increase of NX during recessions.

      • Northern European countries during Great Depression

    • By revaluing the currency and slowing the economy during inflationary booms.

      • China??

When r doesn t equal r
When r Doesn’t Equal r* would be effective to

  • When risk, uncertainty in one country is higher than the rest, this country will be in equilibrium at a higher interest rate than the rest of the world.

  • When a country’s currency is expected to appreciate, the only way capital flow will stop is if the interest rate is lower than the rest of the world.

Increase in the country risk premium
Increase in the Country Risk Premium would be effective to

As the country risk

premium rises, the

local real interest rate

becomes higher than

the world interest rate.

Higher interest rate will

curb some of the

investments, and at

each and every e, IS*

will shift to the left.

Higher interest rate

lowers the demand for

money and forces LM*

to shift right. MAYBE!!

Increase in the country risk premium1
Increase in the Country Risk Premium would be effective to



The top diagram is the same as previous

slide. Higher r reduces IS but increases

LM. In the bottom slide, this should show

as a disequilibrium, since r is on the vertical


But, wait. Top diagram says e has come

down quite a bit: domestic currency has

depreciated a lot. This should stimulate

NX. It was a movement along the IS*

line at the top diagram but it will be a

shift to the right of IS line at the bottom.








Increase in the Country Risk Premium would be effective to



If risk premium is higher because of

increased uncertainty, instead of lowering

money demand, people might hoard cash.

This would shift LM* left.

But e has come down, so NX must have

increased. This will shift IS to the right in

the bottom diagram.





Likewise, if CB doesn’t want large

depreciation, it might shift LM* left.




The impossible trinity
The Impossible Trinity would be effective to

When a country chooses one of the sides of the triangle, it gives up the opposing

corner. Is it better to live with exchange rate volatility, or to give up independent

monetary policy, or to not participate in the world financial markets?

Mundell fleming as a theory of aggregate demand
Mundell–Fleming as a Theory of Aggregate Demand would be effective to

Up until now we dealt with e because in

the short run we can take price levels in

both countries as sticky. In reality, NX

depends on the real exchange rate.


If we want to derive the AD from the M-F

model, we have to change the vertical

axis of IS*LM* to real exchange rate.

When the price level (P) falls, the real

money balances increase, shifting LM*

right. The lower P means the real

exchange rate has fallen as well,

increasing NX along the IS* curve.



Sr blue and lr red equilibria in a small open economy
SR ( would be effective to Blue) and LR (Red) Equilibria in a Small Open Economy

The short run equilibrium takes place at a

recessionary level. High unemployment and

idle capacity forces prices to fall. Lower input

prices increase employment of labor and

capital until the economy is fully employed.

Observe that the vertical axis in IS*-LM* is real

exchange rate. As the domestic price level falls,

so does the real exchange rate [(€/$)(PUS/PEU).

As a result, NX increases along with I because

lower P means lower interest rate (Fisher effect).

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