Lecture 15 (Ch11)

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The Mundell-Fleming model 
2013 
General short run macroeconomic equilibrium 
 
 
 
 
 
 
 
 
 
Goods 
Market 
Money 
Market 
Interest rates affect 
aggregate demand 
Income influences 
demand for money 
…in the open the economy 
 
Goods 
Market 
Money 
Market 
International 
capital 
markets 
Real exchange 
rates affect 
aggregate 
demand 
Interest rates 
influence 
the exchange rate 
Interest rates affect 
aggregate demand 
Income influences 
demand for money 
Outline 
1. The assumptions of the Mundell-Fleming model 
1. Interest rate parity 
 
2. Defining the general equilibrium 
1. Equilibrium under flexible exchange rates 
2. Equilibrium under fixed exchange rates 
 
3. The Impossible Trinity 
 
4. Case study: China 
 
5. Conclusion 
 
Overview 
The Mundell-Fleming model 
 Extension of the IS-TR model for the open economy with 
internationally integrated financial markets 
 Key variable: exchange rate 
 
 
 
 Assumptions 
 Sticky prices 
 Small open economy 
 Small: influenced by changes in the rest of the world, but no impact on 
the rest of the world 
 Open: free international trade & financial openness 
1. The Mundell-Fleming model 
Robert Mundell 
Nobel prize 1999 
Openness and economic size, 2004 
Share of Trade 
world GDP 
(%) 
openness 
(% of GDP) 
Total assets 
(% of GDP) 
Total liabilities 
(% of GDP) 
Denmark 0.6 40.9 55.4 47.4 
Poland 0.6 40.0 31.6 84.9 
Sweden 0.8 42.3 213.5 223.0 
Belgium 0.9 82.3 425.2 394.3 
Switzerland 0.9 40.6 570.7 439.9 
Netherlands 1.4 62.7 402.5 408.3 
Brazil 1.5 15.7 28.3 77.6 
Korea, Rep. 1.6 41.9 52.6 56.6 
China 4.7 32.7 195.3 207.8 
UK 5.1 26.4 357.4 370.6 
Germany 6.6 35.5 167.1 159.1 
Japan 11.2 11.0 89.0 51.0 
Euro countries 23.0 10.8 
US 28.4 11.8 84.0 106.7 
Financial openness 
1. The Mundell-Fleming model 
International capital flows 
 interest rate parity condition 
 If international capital markets are perfectly integrated, the 
rate of return (in the same currency) on assets sharing the 
same risk profile should be identical. 
 
i=i* 
 i = domestic interest rate 
 i* = international rate of return 
 
 If i≠i* : Investors would be able to make profits by 
borrowing in one market and lending in the other. 
 Arbitrageurs (international investors) guarantee that when capital 
markets are fully integrated i=i* 
1.1. The Mundell-Fleming model 
IFM schedule 
 Equilibrium on the international financial markets (IFM) 
i* 
In
te
re
s
t 
ra
te
 
Output 
i > i*, capital flows in 
i i*  capital inflow 
  σ   IS shifts left 
 If i i* will attract capital inflows, so S appreciates 
 
i* 
In
te
re
s
t 
ra
te
 
IS 
A 
B 
IS ́
However, the 
resulting increase 
in S will reduce 
the demand for 
goods. 
Output 
IFM 
TR 
Fiscal policy is 
ineffective 
2.1. Defining the Macroeconomic equilibrium –flexible exchange rates 
Real demand disturbances 
 Why is a shift in IS inefficient? 
 IS shifts following an increase in the demand for domestic 
goods  IS shifts right 
 Raise in income has increased money demand and i 
 Higher i leads to exchange rate appreciation (capital inflow) 
 Appreciation of S continues as long as i > i* 
 Appreciation decreases demand for our exports  higher G 
is compensated by lower PCA  IS shifts back 
 
 We end up at the initial equilibrium 
 
 Chapter 10: higher i crowded investment (partly) out 
 Here: exchange rate appreciation reduces exports 
 
2.1. Defining the Macroeconomic equilibrium –flexible exchange rates 
Expansionary monetary policy 
24 
i* 
IFM 
In
te
re
s
t 
ra
te
 
TR 
IS 
A 
IS ́
C 
TR ́
B 
Capital outflow leads 
to a depreciation of 
the exchange rate  
net exports increase 
OutputMonetary policy 
is effective 
2.1. Defining the Macroeconomic equilibrium –flexible exchange rates 
Expansionary monetary policy: TR curve 
 Monetary policy under flexible exchange rates, TR curve 
 
D(Y) 
i* i* IFM 
IS ́IS 
D´́(Y‘‘) 
Real money 
stock 
Output 
A 
A 
B B 
C 
In
te
re
s
t 
ra
te
 
In
te
re
s
t 
ra
te
 
C 
D (́Y‘) 
2.1. Defining the Macroeconomic equilibrium –flexible exchange rates 
A‘ 
A‘ i‘ 
Y Y‘‘ 
Expansionary monetary policy 
 CB sets i’