1. Sandeep_basnyat@yahoz.com Mobile: 9841 892281
Macroeconomics & The Global Economy -Term III Ace Institute of Management Session 10: The Mundell-Fleming Model and Exchange Rate Regime
Instructor
Sandeep Basnyat
Mobile:

2. IS-LM and Mundell-Fleming Model
IS-LM: relationship between interest rate (r) and output (Y)- IS is the negative relationship where as LM is the positive relationship.
Mundell-Fleming: relationship between nominal exchange rate (e) and output (Y).
Argue that: an economy can not simultaneously maintain fixed exchange rate, free capital movement and independent monetary policy.

3. Mundell-Fleming Model: The IS* curve: Goods market eq’m
Equation for IS Curve: Y = C+I+G+NX (e)
The IS* curve is drawn for a given value of r*.
Intuition for the slope: Y e
IS*
CHAPTER 12 The Open Economy Revisited

4. The LM* curve: Money market eq’m
LM represents money supply by central bank, which is fixed for certain level of output.
The LM* curve does not depend on e and is vertical to e. Y e
LM*
CHAPTER 12 The Open Economy Revisited

5. Equilibrium in the Mundell-Fleming modelY e
LM*
IS*
equilibrium
exchange
rate
equilibrium
level of
income
CHAPTER 12 The Open Economy Revisited

6. Floating & fixed exchange rates
In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions.
In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.
Next, policy analysis –
first, in a floating exchange rate system
then, in a fixed exchange rate system
CHAPTER 12 The Open Economy Revisited

7. Fiscal policy under floating exchange rates
At any given value of e, a fiscal expansion shifts IS* to the right, increasing e.
Therefore, in Floating exchange rate system, fiscal policy is ineffective in increasing output Y e e2 e1
Notes: Increase in G, shifts IS curve to the right, Y increases. But, money supply is fixed, so, shortage of domestic currency reduces national savings and increases nominal exchange rate and reduces export which will decrease Y. Net effect is Y remain constant and e increases. Y1
CHAPTER 12 The Open Economy Revisited

8. Monetary policy under floating exchange rates
An increase in M shifts LM* right .
Y increases and e decreases.
Therefore, in Floating exchange rate system, monetary policy is effective in increasing output Y e Y1 e1
Notes for students: When money supply increases, e decreases as national saving increases. Similarly, decrease in e increases the export and increases value for Y e2 Y2
CHAPTER 12 The Open Economy Revisited

9. Fiscal policy under fixed exchange rates
Under floating rates, a fiscal expansion would raise e.
Under floating rates, fiscal policy is ineffective at changing output.
Under fixed rates, fiscal policy is very effective at changing output. Y e
To keep e from rising, the central bank must sell domestic currency, which increases M and shifts LM* right. e1 Y1 Y2
CHAPTER 12 The Open Economy Revisited

10. Monetary policy under fixed exchange rates
An increase in M would shift LM* right and reduce e.
Under floating rates, monetary policy is very effective at changing output.
Under fixed rates, monetary policy cannot be used to affect output. Y e Y1 e1
To prevent the fall in e, the central bank must buy domestic currency, which reduces M and shifts LM* back left.
Results:
e = 0, Y = 0
CHAPTER 12 The Open Economy Revisited

11. 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 & hyperinflation.
CHAPTER 12 The Open Economy Revisited

12. The Impossible Trinity
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
A nation must choose one side of this triangle and give up the opposite corner.
Free capital flows
Independent monetary policy
Fixed exchange rate
Option 1 (U.S.)
Option 2 (Nepal)
Option 3 (China)
CHAPTER 12 The Open Economy Revisited

13. Thank You