CHAPTER 8.

SMALL OPEN
ECONOMY IN THE SHORT RUN:
THE MUNDELL-FLEMING
MODEL
OVERVIEW
 The Mundell-Fleming model: IS*-LM* model for the
small open economy that used to explain
 how the total output of an open economy is determined
and how does it fluctuate.
 how policies and shocks affect income and the exchange
rate.
 Fixed and floating exchange rate systems
 Causes and effects of interest rate differentials
THE MUNDELL-FLEMING MODEL

 Key assumptions:
 Small open economy
 Perfect capital mobility
 Take the world interest rate as given r = r*
THE MUNDELL-FLEMING MODEL
 The model comprises two curves: IS* and LM*
 The IS* curve shows the various combinations of output
and the exchange rate when the goods market is in
equilibrium.

Y  C (Y  T )  I (r*)  G  NX (e)

 The LM* curve shows the various combinations of output

and the exchange rate when the money market is in
equilibrium.
M S / P  L(r*,Y )
DERIVING THE IS* CURVE
 Aggregate spending: AE2 =C+I+G+NX(e2)
AE = C + I + G + NX AE E2
 At the exchange rate e = e1 net AE1 =C+I+G+NX(e1)
export NX = NX1, aggregate
expenditure AE1 determines E1
equilibrium output Y1.
A (e1,Y1) belong to the IS* curve.
 At the exchange rate e = e2 net Y
Y1 Y2
export NX = NX2, aggregate e
expenditure AE2 determines A
e1
equilibrium outputY2.
B (e2,Y2) belong to the IS* curve. B
e2
 The IS* curve is downward
sloping, that shows a negative IS*
relationship between the exchange
rate and equilibrium output. Y
Y1 Y2
SHIFTS IN THE IS* CURVE
 The IS* curve will shift when there is a change in
 Consumption
 Investment
 Government spending
 Government taxes or subsidies
 Net exports
SHIFTING THE IS* CURVE: CHANGE IN
CONSUMPTION SPENDING
AE AE2 = C2+I+G+NX(e1)
At any value of e, C
E2 AE1 = C1+I+G+NX(e1)
 AE
 Y E1

… so the IS* curve

shifts to the right. Y1 Y2 Y
e

A B
e1

IS*2
IS*1
Y1 Y2 Y
DERIVING THE LM* CURVE
 The LM* curve is derived from the money market.
 The real money supply:

M / P   M S / P
S

 The money demand depends on the income and the interest

rate:
M / P   L(r , Y )
D

 The money market is in equilibrium when money supply is

equal money demand.
M S / P  L( r , Y )
DERIVING THE LM* CURVE
 The standard LM curve is upward sloping, that shows a
positive relationship between the interest rate and output
level.
 At the world interest rate r = r*, the level of output is
determined.
 Disregard of the exchange rate, the output level is fixed
→ the LM* curve is vertical.
DERIVING THE LM* CURVE
r r LM
r2
r2
B
r* r*
r1 r1 C
L2(Y2) A
L1(Y1)
Y
MS /P M/P Y1 Y2
e LM*

Y* Y
SHIFTS IN THE LM* CURVE
 The LM* curve will shift when there is a change in
 The price level
 The nominal money supply
 The world interest rate
 Shocks from money demand
SHIFTS IN THE LM* CURVE: CHANGE IN NOMINAL
MONEY SUPPLY
r r LM1

r2 LM2
C
r* A
r1 E1 r1 C'
E2
r2 r2 B
L1(r,Y1)
Y
M S 1 / P M S 2 / P M/P Y1 LM*1 LM*2
e

An increase in nominal money

supply shifts the LM* curve to
the right.

Y*1 Y*2 Y
THE MUNDELL – FLEMING MODEL
 IS* curve: Equation for equilibrium in goods market
Y = AE = C + I(r*) + G + NX(e)
 LM* curve: Equation for equilibrium in money market

 The economy M / P  L(r*,

is inS equilibrium at Y
the) intersection of the
IS* and LM* curves.
IS* = LM*
 At the equilibrium, the level of output and the exchange
rate are determined.
EQUILIBRIUM IN THE MUNDELL-
FLEMING MODEL
e
LM*

E
eE

IS*

Y
YE
THE EXCHANGE RATE SYSTEMS
 The exchange rates are determined in the foreign
exchange market.
 There are two types of exchange rate systems:
 Flexible or floating exchange rate system: exchange rates
are allowed to fluctuate in response to changing market
conditions.
 Fixed exchange rate system: the government determines
exchange rates and will intervene in the foreign exchange
market to maintain those rates.
FOREIGN EXCHANGE MARKET

e  Under floating
exchange rate
Sdc
system, the
exchange rate is
determined at the
eE E equilibrium of the
foreign exchange
market.
Ddc

Qdc
FOREIGN EXCHANGE MARKET
 Under fixed
e Sdc exchange rate
system, the central
bank sets a fixed
e exchange rate.
 If the market
eE exchange rate is
lower than the fixed
exchange rate, the
D2dc central bank will
D1dc
buy domestic
currency in order to
Qdc keep the exchange
rate unchanged.
FOREIGN EXCHANGE MARKET
S1dc  Under fixed
e S2dc exchange rate
system, the central
bank sets a fixed
exchange rate.
eE  If the market
exchange rate is
𝑒 higher than the
fixed exchange rate,
the central bank
Ddc will sell domestic
currency in order to
Qdc keep the exchange
rate unchanged.
EFFECTS OF POLICIES UNDER FLOATING
EXCHANGE RATE SYSTEM

1. Fiscal policy

2. Monetary policy

3. Trade policy
1. FISCAL POLICY UNDER FLOATING
EXCHANGE RATE SYSTEM

Expansionary fiscal policy

(G↑ or T↓ ) shifts the IS* LM*
e
curve to the right.
E2
e2

Result: E1
e1
 Exchange rate increases
IS*2
 Total output is
unchanged. IS*1
Y1 Y
1. FISCAL POLICY UNDER FLOATING
EXCHANGE RATE SYSTEM
 Initially the economy is at equilibrium E1:
e = e1 ; Y = Y 1
 Event: The government conducts expansionary fiscal policy. Government spending
increases; tax decreases → disposable income increases → consumption increases.
↑AE = C↑ + I + G↑ + NX
Aggregate expenditure increases → The IS* curve
shifts to the right.
The economy reaches the new equilibrium at E2:
e = e2 ; Y = Y 1
e2 > e1 : Exchange rate increases
Y = Y1 : Total output is unchanged
Conclusion: Expansionary fiscal policy leads to a higher exchange rate and unchanged
total output.
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.
2. MONETARY POLICY UNDER FLOATING
EXCHANGE RATE SYSTEM

Expansionary monetary
policy (money supply LM*1 LM*2
e
increases) shifts the LM*
curve to the right.

Results: E1
e1
 Exchange rate decreases.
E2
 Total output increases. e2
IS*
Y1 Y2 Y
TRADE POLICY
 Trade policy is conducted to affect net exports.
 Tariff
is a tax imposed on imported goods.
 Quota is a limit on quantity of foreign goods imported.
 Import restriction policy (Higher tariff or lower quota on
imported goods)
 Import relaxation policy (Lower tariff or higher quota on
imported goods)
3. TRADE POLICY UNDER FLOATING
EXCHANGE RATE SYSTEM

Government imposes tariff

on imported goods  LM*
e
Import  ↑NX  the IS*
curve shifts to the right. E2
e2

e1 E1
Result:
 Exchange rate increases. IS*2
 Total output is
IS*1
unchanged.
Y1 Y
TRADE POLICY UNDER FLOATING EXCHANGE
RATE SYSTEM
 Initially the economy is at equilibrium E1:
e = e1 ; Y = Y1
 Event: The government imposes tariff on imported goods → import decreases → net export
increases (1)
↑AE = C + I + G + NX↑
Aggregate expenditure increases → The IS* curve shifts to the right.
The economy reaches the new equilibrium at E2:
e = e2 ; Y = Y1
e2 > e1 : Exchange rate increases → Domestic goods become relatively more expensive
compared to foreign goods → export decreases and import increases → net export decreases (2)
Combine (1) and (2): Net export is unchanged
Y = Y1 : Total output is unchanged
Conclusion: Tariff on imported goods leads to a higher exchange rate and unchanged total
output.
FIXED EXCHANGE RATES
 This system fixes the nominal exchange rate.
 Under a system of fixed exchange rates, the country’s
central bank stands ready to buy or sell the domestic
currency for foreign currency at a predetermined rate.
 In the context of the Mundell-Fleming model, the central
bank shifts the LM* curve as required to keep e at its
preannounced rate.
EFFECTS OF POLICIES UNDER FIXED
EXCHANGE RATE SYSTEM

1. Fiscal policy

2. Monetary policy

3. Trade policy
1. FISCAL POLICY UNDER A FIXED
EXCHANGE RATE SYSTEM

Expansionary fiscal policy LM*1 LM*2

e
(G↑ or T↓ ).

Result: E1
 Exchange rate is
𝑒 E2

unchanged. IS*2
 Total output increases. IS*1
Y1 Y
Y2
FISCAL POLICY UNDER FIXED EXCHANGE RATE SYSTEM

 Initially the economy is at equilibrium E1:

e= ; Y = Y1 e
 Event:
The government conducts expansionary fiscal policy (G increases or T
decreases).
↑AE = C↑ + I + G↑ + NX
Aggregate expenditure increases → The IS* curve shifts to the right and puts upward
pressure on exchange rate. To keep the exchange rate unchanged, the central bank must
sell domestic currency, which increases money supply and shifts the LM* curve to the
right.
The economy reaches the new equilibrium at E2:
e
e= ;e
Y = Y2
e= : Exchange rate is unchanged
Y2 > Y1 : Total output increases
Conclusion: Expansionary fiscal policy leads to a higher total output under fixed
exchange rate system.
1. MONETARY POLICY UNDER A FIXED
EXCHANGE RATE SYSTEM

Expansionary monetary LM*1 LM*2

policy (money supply e
increases).

Result: E1
 Exchange rate is
𝑒
unchanged.
 Total output is IS*1
unchanged. Y
Y1
1. TRADE POLICY UNDER A FIXED
EXCHANGE RATE SYSTEM

Government imposes tariff LM*1 LM*2

on imported goods. e

Result:
E1 E2
 Exchange rate is 𝑒
unchanged.
IS*2
 Total output increases.
IS*1
Y1 Y
Y2
SUMMARY OF POLICY EFFECTS

Type of exchange rate regime

Floating Fixed
impact on:
Policy Y e NX Y e NX

Fiscal expansion 0    0 0

Monetary expansion    0 0 0

Import restriction 0  0  0 
FLOATING VS. FIXED EXCHANGE RATES
 Argument for floating rates
 Allows monetary policy to be used to pursue other goals
(stable growth, low inflation).
 Arguments for fixed rates:
 Avoids uncertainty and volatility, making international
transactions easier.
 Disciplines monetary policy to prevent excessive money
growth and hyperinflation.
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:
 Ifa 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.
THE MUNDELL-FLEMING MODEL:
INTEREST RATE DIFFERENTIALS

r  r * 
 where  is a risk premium.
 Substitute the expression for r into the IS* and LM*
equations:

Y  C (Y  T )  I (r *  )  G  NX (e)
M S / P  L(r *  , Y )
THE MUNDELL-FLEMING MODEL:
INTEREST RATE DIFFERENTIALS

The effects of an increase in θ:

 The IS* curve shifts left. e LM*1 LM*2
 The LM* curve shifts right.
 Results: exchange rate
e1 E1
decreases.
 Increase in country risk or
fall in expected exchange
rate causes the country’s e2 E2 IS*1
currency to depreciate. IS*2
Y
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 even greater than the fall in I
(from the rise in r).