Macroeconomic Policies in the Mundell-Fleming Model

Giovanni Di Bartolomeo
2003 A note for the students
In this note we summarize the effects of monetary and fiscal policy in an open economy
by using the Mundell-Fleming Model. For the sake of exposition, we illustrate the perfect
capital mobility cases only. Moreover, bear in mind that we are considering the case of a
small-open economy (only one policymaker acts).
Since we consider both the fixed and flexible exchange regime four cases are possible.
The cases are summarized in the following figure.
fixed exchange rate regime

monetary policy

IS

LM

flexible exchange rate regime

LM1

IS

BB
B

IS

IS1

LM

LM2

yE
i

IS

yV

IS1

y
LM

B
E

BB

1
yE

LM1

fiscal policy

LM

BB

IS2

B
V

BB

2
yE

yV

yE

The four cases can be explained as follows.

1. First consider the case of an expansionary monetary policy in a fixed exchange
rate regime (top-left panel). A monetary expansion shifts the LM curve right (1).
This implies a deficit of the balance of payments (point B). In the foreign

currency market there is an excess of demand because of the balance of payments

deficit, the deficit tends raise the price of the foreign currency up. Hence, in order
to keep the exchange rate constant, the central bank has to supply foreign
currency. The central bank sells on the international market part of its foreign
currency reserves and the consequent reduction in the quantity of money shifts the
LM back to point E. The monetary policy has not real effects in the fixed
exchange rate regime. Any attempt to raise the level of real output by monetary
policy fails and implies a reduction of the foreign currency reserves of the central
bank.
2. By contrast, the case of a monetary expansion in the flexible exchange rate regime
is different (top-right panel). In the case of flexible exchange rate regime, a
monetary expansion (1) also implies a deficit of the balance of payments (point
B). The excess of demand of foreign currency (because of the balance of
payments deficit) raises the price of the foreign currency up (exchange rate
depreciation). Depreciation implies an increase of the domestic-country
competitiveness that shifts the IS right (2) and the new equilibrium is point V. The
monetary policy is able to raise the real output.
3. Now consider the fiscal policy in a fixed exchange regime (bottom-left panel). In
a fixed exchange rate regime a fiscal expansion shifts the IS curve right (1). The
surplus of the balance of payments tends to reduce the price of foreign currency.
In order to keep the exchange rate fixed the central bank has to accommodate the
fiscal policy by selling its reserves. Hence, the LM curve shifts right (2) and the
fiscal policy affects the real output level. The new equilibrium results to be point
V.
4. Finally, consider the case of the fiscal policy in a flexible exchange rate regime
(bottom-right panel). A fiscal expansion shifts the IS curve right (1) and implies a
surplus of the balance of payments. The surplus of the balance of payment implies
an excess of supply in the foreign currency market. Hence, the exchange rate and
competitiveness fall. The competitiveness reduction shifts (2) the IS curve back to
point B. Fiscal policy does not affect real output.
Remarks
a. We have defined the exchange rate as the foreign currency price in terms of the
domestic one (price quotation system). E.g. the exchange rate of the Euro in the
United States is the dollar price of one Euro.
PEU E
(competitiveness is measured
PUS
in dollars), if the exchange rate rises, the competitiveness rises too.

b. According to our competitiveness index C =

c. A surplus of the balance of payments (current account) implies that exports are
larger than imports. Hence, domestic residents are net creditors and foreign
residents are net debtors. Assuming that domestic residents are interested in
holding domestic currency and foreign resident foreign currency, in the foreign
currency market there is an excess of supply of foreign currency. The excess of
supply tends to reduce the price of the foreign currency (i.e. the exchange rate).