Macroeconomics & The Global
Economy -Term III
Ace Institute of Management
Session 10: The Mundell-Fleming Model
and Exchange Rate Regime
Instructor
Sandeep Basnyat
Sandeep_basnyat@yahoz.com
Mobile: 9841 892281
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.
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*.
e
Intuition for the slope:
 e   NX
 Y
IS*
Y
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The LM* curve: Money market eq’m
LM represents money
supply by central bank,
which is fixed for
certain level of output.
e
LM*
The LM* curve does not
depend on e and is
vertical to e.
Y
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Equilibrium in the Mundell-Fleming model
e
LM*
equilibrium
exchange
rate
equilibrium
level of
income
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IS*
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Y
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
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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
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e
*
LM 1
e2
e1
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*
IS 2
*
IS 1
Y1
Y
Monetary policy under floating exchange
rates
An increase in M
shifts LM* right .
e
*
*
LM 1 LM 2
Y increases and e
decreases.
Therefore, in Floating
exchange rate system,
monetary policy is
effective in increasing
output
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e1
e2
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*
IS 1
Y1 Y2
Y
Fiscal policy under fixed exchange rates
Under
rates,
Underfloating
floating
rates,
afiscal
fiscalpolicy
expansion
is ineffective
would
raise e. output.
at changing
To
keepfixed
e from
rising,
Under
rates,
the
central
bank
must
fiscal
policy
is very
sell
domestic
currency,
effective
at changing
which
increases M
output.
and shifts LM* right.
e
*
e1
*
IS 2
*
IS 1
Y1 Y2
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*
LM 1 LM 2
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Y
Monetary policy under fixed exchange
rates
An
increase
in Mrates,
would
Under
floating
monetary
policy
shift
LM* right
andisreduce e.
e
very
effective
at
To prevent the fall in e,
changing
the
central output.
bank must
buy
domestic
currency,
Under
fixed rates,
which
reduces
M and
e1
monetary
policy
cannot
shifts
LM*toback
left.output.
be used
affect
*
*
IS 1
Results:
e = 0, Y = 0
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*
LM 1 LM 2
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Y1
Y
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.
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The Impossible Trinity
A nation cannot have free
Free capital
capital flows, independent
flows
monetary policy, and a
fixed exchange rate
Option 2
Option 1
simultaneously.
(Nepal)
(U.S.)
A nation must choose
one side of this
triangle and
Independent
give up the
monetary
opposite
policy
corner.
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Option 3
(China)
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Fixed
exchange
rate
Thank You
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