TOPIC 3: THE MUNDELL-FLEMING MODEL

1. CONSTRUCTING THE MUNDELL-FLEMING MODEL

Key assumption: world interest rate

There is perfect capital mobility, so the interest rate of an economy is determined by the world
interest rate. The world interest rate is exogenously fixed because the economy is small
enough to not affect it.
r=r*

Why? If the interest rate of an economy is, for example, above the world interest rate, this will
attract investors from abroad, so there will be a high capital inflow. This capital inflow will
cause the interest rate to decrease until reaching the world interest rate

The goods market and the IS* curve

Net exports are added to the goods market

Y = C(Y-T) + I(r) + G + NX(e)

e= Exchange rate, the amount of foreign currency per unit of domestic currency
NX depends negatively on e
Nominal or real? → it is assumed that price level at home and abroad are fixed, and as
ε= eP/P*, both are proportional

Now, the IS equation has only one variable, the exchange rate, as the interest rate is
exogenously fixed
Y=C+I(r*)+G+NX(e)

Which gives us a new relationship for the IS curve (we call it IS* curve)
The money market and the LM* curve

The LM equation is now

LM*: M/P = L(r*,Y)

If we build the LM* curve, showing the relationship between income and the exchange rate,
we obtain a vertical line, as the exchange rate is not included in the LM equation.

The IS* and LM* curves together

IS: Y=C+I(r*)+G+NX(e)
LM: M/P= L(r*,Y)
The first equation describes equilibrium in the goods market; the second describes equilibrium
in the money market. The exogenous variables are fiscal policy G and T, monetary policy M,
the price level P, and the world interest rate r*. The endogenous variables are income Y and
the exchange rate e
 2. THE SMALL OPEN ECONOMY UNDER FLOATING EXCHANGE RATES

An economy under a system of floating exchange rates allows the exchange rate to fluctuate
responding to economic conditions in order to readjust and set simultaneous equilibrium in
the money and goods market.

Fiscal policy

A fiscal policy affects the exchange rate but hold income constant. Why?

o Imagine that government increases G →income increases

o In a closed economy, this would rise the demand for money and the interest rate, but
in a small open economy the interest rate always ends up being fixed at the world
interest rate
o However, because of the beginning inflow of capital, investors from abroad need
domestic currency to invest in domestic products, so the domestic currency
appreciates
o Exchange rate increases → net exports decrease → income decreases
o The fall in net exports exactly offsets the effects of the expansionary fiscal policy on
income

Monetary policy

A monetary policy affects both the exchange rate and the income. Why?

o Imagine an increase in money supply

o r decreases at the beginning (although it always ends up fixed in r*), so there is a
capital outflow, which causes the readjustment to r*
o because of the beginning outflow → domestic currency depreciates → e decreases
o As e decreases → NX increase → income increases
Trade policy

A trade policy affects the exchange rate but holds income constant. Why?

o Imagine that the government imposes a tariff to imports → IM decrease → NX

increase
o NX increase → income increase → money demand increase → upward pressure on r
o Capital inflow → r returns to be fixed at r*
o Because of the beginning pressure → domestic currency appreciates → e increases
o e increases → NX decrease → compensate the beginning increase of NX to hold
income constant
 3. THE SMALL OPEN ECONOMY UNDER FIXED EXCHANGE RATES

In an economy under a system of fixed exchange rates, the central bank announces a value
for the exchange rate and stands ready to buy and sell the domestic currency to keep the
exchange rate at its announced level .

How does it work?

o Imagine the ECB fixes exchange rate at 2$ per €, but in the market, the exchange rate
is 3$ per €
o There is an opportunity for investors: an investor buys 3$ paying 1€ at the foreign
exchange market, and sells the dollars to the ECB at the fixed exchange rate and
getting a profit of 0.5€
o Buying the dollars, the ECB pays in euros, so it is increasing the supply of €
o Increase of money supply → LM* curve moves to the right → e decreases until
reaching the fixed exchange rate

Fiscal policy

A fiscal policy can increase or decrease income. Why?

o Imagine government increases G → IS* curve moves to the right

o This causes the exchange rate to increase in the new equilibrium, but as we are under
a system of fixed exchange rate, investors sell foreign currency to the central bank
increasing money supply
o Increase in money supply → LM* curve moves to the right → new equilibrium: e
returns to the fixed level and income increases
Monetary policy

If the Central Bank increases money supply:

o LM* curve shifts rightwards → e decreases
o Investors sell domestic currency to the central bank → money supply decreases →
LM* curve shifts leftwards, until returning to the fixed exchange rate level

However, there is another type of monetary policy: devaluation or revaluation of the

domestic currency. This happens when the Central Bank changes the fixed exchange rate,
shifting the LM* curve.

o Devaluation → LM* curve moves rightwards → e decreases → NX increase → Y

increase
o Revaluation → LM* curve shifts rightwards → e increases → NX decrease → Y
decrease

Trade policy

Government imposes a tariff on imports:

o NX increase → IS* curve moves rightwards → new equilibrium: same income and
higher e
o As there is higher e than fixed → investors sell foreign currency to the central bank →
money supply increases → LM* curve shifts rightwards until reaching the fixed e
 o New equilibrium: fixed e, higher income

4. INTEREST RATE DIFFERENTIALS

Until now, we have assumed that r=r*. In reality, the interest rate of an economy does differ
from the world interest rate. Why?

Risk premium: in some countries, people are more confident that their loan will be repaid than
in other countries, that is, the risk that a loan will not be repaid is higher in some countries
than in others. Because of that, the countries with higher risk premium compensate this risk
with a higher interest rate.

Exchange rate expectations: if it is expected that a currency is going to be devaluated, that is, it
is going to lose value relative to other currencies, loans with that currency will give lower
returns relative to other currencies. To compensate this, higher interest rates are offered.

Differentials in the Mundell-Fleming model

Now, the interest rate of an economy is:

r= r* + θ, where θ is the risk premium

So, the new IS* and LM* equations:

IS*: Y=C+I(r*+ θ)+G+NX(e)
LM*: L(r*+ θ,Y) = M/P

For any given fiscal policy, monetary policy, price level, and risk premium, these two equations
determine the level of income and exchange rate that equilibrate the goods market and the
money market. Holding constant the risk premium, the tools of monetary, fiscal, and trade
policy work as we have already seen.

What happens if the risk premium of a country increases?

o Increase in θ → increase in r → investment decreases → IS* curve moves leftwards
o Increase in r → Y must increase to satisfy LM* equation → LM* curve shifts rightwards
o New equilibrium: lower e, higher Y
However, this does not end in this situation. In fact, three events happen:
o Central Bank might avoid such a depreciation of the domestic currency, so it might
reduce the money supply
o The depreciation of the currency might trigger an increase in prices of imported goods,
increasing the aggregate price level P
o Because of the rise of risk premium, people might increase the demand of money as it
is the safest asset
o These three events cause LM* curve to shift leftwards, so, in fact, a rise in risk
premium does not increase a country’s income, it ends up decreasing it

5. LONG-RUN: MUNDELL-FLEMING MODEL WITH A CHANGING PRICE LEVEL

In the long-run, the price level is not fixed, so the nominal and the real exchange rates are no
longer proportional. We use the real exchange rate
IS*: Y=C+I(r*)+G+NX(ε)
LM*: M/P= L(r*,Y)

If the aggregate price level falls

o The level of real money balances increases → LM*curve shifts rightwards
o New equilibrium: ε decreases, Y increases
o Thus, fall in price leads to increase in Y, so there is a negative relationship from which
we build the aggregate demand curve
If an economy is below the Natural level Y:
o Low aggregate demand → price level falls in the long-run
o Price level falls → real money balances increase → LM* curve shifts rightwards