MundellFleming model

The MundellFleming model, also known as the IS- 1.2 Variables

LM-BoP model (or IS-LM-BP model), is an economic
model rst set forth (independently) by Robert Mundell This model uses the following variables:
and Marcus Fleming.[1][2] The model is an extension
of the IS-LM Model. Whereas the traditional IS-LM
Y is GDP
Model deals with economy under autarky (or a closed
economy), the MundellFleming model describes a small
C is consumption
open economy. Mundells paper suggests that the model
I is physical investment
can be applied to Zurich, Brussels and so on.[1]
The MundellFleming model portrays the short-run relationship between an economys nominal exchange rate,
interest rate, and output (in contrast to the closedeconomy IS-LM model, which focuses only on the relationship between the interest rate and output). The
MundellFleming model has been used to argue that
an economy cannot simultaneously maintain a xed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called
the "impossible trinity, unholy trinity, irreconcilable
trinity, inconsistent trinity or the MundellFleming
trilemma.

G is government spending (an exogenous variable)

M is the nominal money supply
P is the price level
i is the nominal interest rate
L is liquidity preference (real money demand)
T is taxes
NX is net exports

1.3 Equations

Basic set up

1.1

The MundellFleming model is based on the following

equations.

Assumptions

The IS curve:

Basic assumptions of the model are as follows:[1]

Spot and forward exchange rates are identical, and

the existing exchange rates are expected to persist Y = C + I + G + N X
indenitely.
where NX is net exports.
Fixed money wage rate, unemployed resources and
constant returns to scale are assumed. Thus domes- The LM curve:
tic price level is kept constant, and the supply of domestic output is elastic.
M
= L(i, Y )
Taxes and saving increase with income.
P
The balance of trade depends only on income and
A higher interest rate or a lower income (GDP) level leads
the exchange rate.
to lower money demand.
Capital mobility is perfect and all securities are per- The BoP (Balance of Payments) Curve:
fect substitutes. Only risk neutral investors are in the
system. The demand for money therefore depends
only on income and the interest rate, and investment
BoP = CA + KA
depends on the interest rate.
The country under consideration is so small that the where BoP is the balance of payments surplus, CA is the
country can not aect foreign incomes or the world current account surplus, and KA is the capital account surplus.
level of interest rates.
1

2 MECHANICS OF THE MODEL

1.4

IS components

Under both types of exchange rate regime, the nominal

domestic money supply M is exogenous, but for dierC = C(Y T (Y ), i E())
ent reasons. Under exible exchange rates, the nominal
money supply is completely under the control of the cenwhere E() is the expected rate of ination. Higher distral bank. But under xed exchange rates, the money
posable income or a lower real interest rate (nominal insupply in the short run (at a given point in time) is xed
terest rate minus expected ination) leads to higher conbased on past international money ows, while as the
sumption spending.
economy evolves over time these international ows cause
future points in time to inherit higher or lower (but predetermined) values of the money supply.
I = I(i E(), Y1 )
where Y is GDP in the previous period. Higher lagged
income or a lower real interest rate leads to higher investment spending.

N X = N X(e, Y, Y )

2 Mechanics of the model

The models workings can be described in terms of an
IS-LM-BoP graph with the domestic interest rate plotted vertically and real GDP plotted horizontally. The IS
curve is downward sloped and the LM curve is upward
sloped, as in the closed economy IS-LM analysis; the
BoP curve is upward sloped unless there is perfect capital
mobility, in which case it is horizontal at the level of the
world interest rate.

where NX is net exports, e is the nominal exchange rate

(the price of domestic currency in terms of units of
the foreign currency), Y is GDP, and Y* is the combined GDP of countries that are foreign trading partners.
Higher domestic income (GDP) leads to more spending
on imports and hence lower net exports; higher foreign income leads to higher spending by foreigners on the coun- In this graph, under less than perfect capital mobility the
trys exports and thus higher net exports. A higher e leads positions of both the IS curve and the BoP curve depend
on the exchange rate (as discussed below), since the ISto lower net exports.
LM graph is actually a two-dimensional cross-section of a
three-dimensional space involving all of the interest rate,
1.5 Balance of payments (BoP) compo- income, and the exchange rate. However, under perfect
capital mobility the BoP curve is simply horizontal at a
nents
level of the domestic interest rate equal to the level of the
world interest rate.
CA = N X
where CA is the current account and NX is net
exports. That is, the current account is viewed
2.1
as consisting solely of imports and exports.

Under a exible exchange rate regime

KA = z(i i) + k

1.6

In a system of exible exchange rates, central banks allow the exchange rate to be determined by market forces
where i is the foreign interest rate, k is the ex- alone.
ogenous component of nancial capital ows,
z is the interest-sensitive component of capital ows, and the derivative of the function z
is the degree of capital mobility (the eect of 2.1.1 Changes in the money supply
dierences between domestic and foreign interest rates upon capital ows KA).
An increase in money supply shifts the LM curve to the
right. This directly reduces the local interest rate relative
to the global interest rate. A decrease in the money supply
Variables determined by the model
causes the exact opposite process.

After the subsequent equations are substituted into the

rst three equations above, one has a system of three
equations in three unknowns, two of which are GDP and
the domestic interest rate. Under exible exchange rates,
the exchange rate is the third endogenous variable while
BoP is set equal to zero. In contrast, under xed exchange
rates e is exogenous and the balance of payments surplus
is determined by the model.

2.1.2 Changes in government spending

An increase in government expenditure shifts the IS curve
to the right. The shift causes both the local interest rate
and income (GDP) to rise. A decrease in government
expenditure reverses the process.

2.2
2.1.3

Under a xed exchange rate regime

Changes in the global interest rate

money by decreasing its holdings of domestic bonds (or

the opposite if money were owing out of the country).
An increase in the global interest rate shifts the BoP curve But under perfect capital mobility, any such sterilization
upward and causes capital ows out of the local econ- would be met by further osetting international ows.
omy. This depreciates the local currency and boosts net
exports, shifting the IS curve to the right. Under less than
perfect capital mobility, the depreciated exchange rate 2.2.2 Changes in government expenditure
shifts the BoP curve somewhat back down.Under perfect
capital mobility, the BoP curve is always horizontal at the
level of the world interest rate. When the latter goes up,
the BoP curve shifts upward by the same amount, and
stays there. The exchange rate changes enough to shift
the IS curve to the location where it crosses the new BoP
curve at its intersection with the unchanged LM curve;
now the domestic interest rate equals the new level of the
global interest rate.
A decrease in the global interest rate causes the reverse
to occur.

2.2

Under a xed exchange rate regime

In a system of xed exchange rates, central banks announce an exchange rate (the parity rate) at which they
are prepared to buy or sell any amount of domestic currency. Thus net payments ows into or out of the country
need not equal zero; the exchange rate e is exogenously
given, while the variable BoP is endogenous.

An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange
rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve)
is horizontal.

Under the xed exchange rate system, the central bank

operates in the foreign exchange market to maintain a
specic exchange rate. If there is pressure to depreciate
the domestic currencys exchange rate because the supply of domestic currency exceeds its demand in foreign
exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currencys supply in the foreign exchange market. This keeps
the domestic currencys exchange rate at its targeted level.
If there is pressure to appreciate the domestic currencys
exchange rate because the currencys demand exceeds its
supply in the foreign exchange market, the local authority
buys foreign currency with domestic currency to increase
the domestic currencys supply in the foreign exchange
market. Again,this keeps the exchange rate at its targeted
level.

Increased government expenditure shifts the IS curve to

the right. The shift results in an incipient rise in the interest rate, and hence upward pressure on the exchange rate
(value of the domestic currency) as foreign funds start to
ow in, attracted by the higher interest rate. However,
the exchange rate is controlled by the local monetary authority in the framework of a xed exchange rate system.
To maintain the exchange rate and eliminate pressure on
it, the monetary authority purchases foreign currency using domestic funds in order to shift the LM curve to the
right. In the end, the interest rate stays the same but the
general income in the economy increases. In the IS-LMBoP graph, the IS curve has been shifted exogenously by
the scal authority, and the IS and BoP curves determine
the nal resting place of the system; the LM curve merely
passively reacts.

2.2.1

The reverse process applies when government expenditure decreases.

Changes in the money supply

In the very short run the money supply is normally predetermined by the past history of international payments
ows. If the central bank is maintaining an exchange rate
that is consistent with a balance of payments surplus, over
time money will ow into the country and the money supply will rise (and vice versa for a payments decit). If the
central bank were to conduct open market operations in
the domestic bond market in order to oset these balanceof-payments-induced changes in the money supply a
process called sterilization, it would absorb newly arrived

2.2.3 Changes in the global interest rate

To maintain the xed exchange rate, the central bank
must accommodate the capital ows (in or out) which are
caused by a change of the global interest rate, in order to
oset pressure on the exchange rate.
If the global interest rate increases, shifting the BoP curve
upward, capital ows out to take advantage of the opportunity. This puts pressure on the home currency to de-

4 CRITICISM

preciate, so the central bank must buy the home currency

that is, sell some of its foreign currency reserves
to accommodate this outow. The decrease in the money
supply resulting from the outow, shifts the LM curve to
the left until it intersect the IS and BoP curves at their
intersection. Once again, the LM curve plays a passive
role, and the outcomes are determined by the IS-BoP interaction.

and output to rise. But for a small open economy with

perfect capital mobility and a exible exchange rate, the
domestic interest rate is predetermined by the horizontal BoP curve, and so by the LM equation given previously there is exactly one level of output that can make
the money market be in equilibrium at that interest rate.
Any exogenous changes aecting the IS curve (such as
government spending changes) will be exactly oset by
resulting exchange rate changes, and the IS curve will
Under perfect capital mobility, the new BoP curve will be
horizontal at the new world interest rate, so the equilib- end up in its original position, still intersecting the LM
and BoP curves at their intersection point.
rium domestic interest rate will equal the world interest
rate.
The MundellFleming model under a xed exchange rate
If the global interest rate declines below the domestic regime also has completely dierent implications from
rate, the opposite occurs. The BoP curve shifts down, those of the closed economy IS-LM model. In the closed
foreign money ows in and the home currency is pres- economy model, if the central bank expands the money
sured to appreciate, so the central bank osets the pres- supply the LM curve shifts out, and as a result income
sure by selling domestic currency (equivalently, buying goes up and the domestic interest rate goes down. But
foreign currency). The inow of money causes the LM in the MundellFleming open economy model with percurve to shift to the right, and the domestic interest rate fect capital mobility, monetary policy becomes ineecbecomes lower (as low as the world interest rate if there tive. An expansionary monetary policy resulting in an incipient outward shift of the LM curve would make capital
is perfect capital mobility).
ow out of the economy. The central bank under a xed
exchange rate system would have to instantaneously intervene by selling foreign money in exchange for domes3 Dierences from IS-LM
tic money to maintain the exchange rate. The accommodated monetary outows exactly oset the intended rise
It is worth noting that some of the results from this model in the domestic money supply, completely osetting the
dier from those of the IS-LM model because of the tendency of the LM curve to shift to the right, and the
open economy assumption. Results for a large open econ- interest rate remains equal to the world rate of interest.
omy, on the other hand, can be consistent with those predicted by the IS-LM model. The reason is that a large
open economy has the characteristics of both an autarky 4 Criticism
and a small open economy. In particular, it may not
face perfect capital mobility, thus allowing internal policy
4.1 Exchange rate expectations
measures to aect the domestic interest rate, and it may
be able to sterilize balance-of-payments-induced changes One of the assumptions of the MundellFleming model
in the money supply (as discussed above).
is that domestic and foreign securities are perfect substiIn the IS-LM model, the domestic interest rate is a
key component in keeping both the money market and
the goods market in equilibrium. Under the Mundell
Fleming framework of a small economy facing perfect
capital mobility, the domestic interest rate is xed and
equilibrium in both markets can only be maintained by
adjustments of the nominal exchange rate or the money
supply (by international funds ows).

3.1

Example

tutes. Provided the world interest rate i is given, the

model predicts the domestic rate will become the same
level of the world rate by arbitrage in money markets.
However, in reality, the world interest rate is dierent
from the domestic rate. Rdiger Dornbusch considered
how exchange rate expectations made an eect on the exchange rate.[3] Given the approximate formula:

i = i +

e
1
e

and if the elasticity of expectations , is less than unity,

The MundellFleming model applied to a small open then we have
economy facing perfect capital mobility, in which the
domestic interest rate is exogenously determined by the
world interest rate, shows stark dierences from the di
=1<0 .
closed economy model.
de
Consider an exogenous increase in government expendi- Since domestic output is y = E(i, y) + T (e, y) , the
ture. Under the IS-LM model, the IS curve shifts up- dierentiation of income with regard to the exchange rate
ward, with the LM curve intact, causing the interest rate becomes

5 See also
dy
E di
E dy T
T dy
=
+
+
+
de
i de
y de
e
y de
(
)
dy
1
di
=
Ei + Te .
de
1 Ey Ty
de
The standard IS-LM theory gives us the following basic
relations:

Ei < 0 ,

Ey = 1 s > 0

Te > 0 ,

Ty = m < 0 .

Investment and consumption increase as the interest rates

decrease, and currency depreciation improves the trade
balance.

dy
1
=
de
s+m

(
)
di
Ei + T e
de

dy
1
=
(Ei ( 1) + Te ) .
de
s+m
Then the total dierentiations of trade balance and the
demand for money are derived.

dT =

T
T
de +
dy = Te de + Ty dy
e
y

dL =

L
L
di +
dy = Li di + Ly dy
i
y

Li < 0 ,

Ly > 0

and then, it turns out that

dT
Te (s + m) + Ty (Ei ( 1) + Te )
=
dL
Li ( 1)(s + m) + Ly (Ei ( 1) + Te )
dT
Te s + Ty Ei ( 1)
=
.
dL
Li ( 1)(s + m) + Ly (Ei ( 1) + Te )
The denominator is positive, and the numerator is positive or negative. Thus, a monetary expansion, in the
short run, does not necessarily improve the trade balance.
This result is not compatible with what the MundellFleming predicts.[3] This is a consequence of introducing
exchange rate expectations which the MF theory ignores.
Nevertheless, Dornbusch concludes that monetary policy
is still eective even if it worsens a trade balance, because a monetary expansion pushes down interest rates
and encourages spending. He adds that, in the short run,
scal policy works because it raises interest rates and the
velocity of money.[3]
See also: interest rate parity and Overshooting model
See also: exchange rate and Capital asset pricing model

Optimum currency area

MarshallLerner condition

6 References
[1] Mundell, Robert A. (1963). Capital mobility and stabilization policy under xed and exible exchange rates.
Canadian Journal of Economic and Political Science 29
(4): 475485. doi:10.2307/139336. Reprinted in
Mundell, Robert A. (1968). International Economics.
New York: Macmillan.
[2] Fleming, J. Marcus (1962). Domestic nancial policies
under xed and oating exchange rates. IMF Sta Papers 9: 369379. doi:10.2307/3866091. Reprinted in
Cooper, Richard N., ed. (1969). International Finance.
New York: Penguin Books.
[3] Dornbusch, R. (1976). Exchange Rate Expectations and
Monetary Policy. Journal of International Economics 6
(3): 231244. doi:10.1016/0022-1996(76)90001-5.

7 Further reading
Young, Warren; Darity, William, Jr. (2004),
IS-LM-BP: An Inquest (PDF), History of
Political Economy 36 (Suppl 1):
127164,
doi:10.1215/00182702-36-Suppl_1-127
(Tells
the dierence between the IS-LM-BP model and the
MundellFleming model.)

Carlin, Wendy; Soskice, David W. (1990), Macroeconomics and the Wage Bargain, New York: Oxford
University Press, ISBN 0-19-877245-9
Mankiw, N. Gregory (2007), Macroeconomics (6th
ed.), New York: Worth, ISBN 978-0-7167-6213-3
Blanchard, Olivier (2006), Macroeconomics (4th
ed.), Upper Saddle River, NJ: Prentice Hall, ISBN
0-13-186026-7
DeGrauwe, Paul (2000), Economics of Monetary
Union (4th ed.), New York: Oxford University
Press, ISBN 0-19-877632-2

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