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IS-LM Model v/s Mundel-Fleming Model

Session-9-10 (Closed v/s Open economy)
Open Economy Macroeconomics • Both models are close relative to each other
(stress the interaction between goods & money markets)
• Both models assume P is fixed and show what
causes short-run fluctuations in AD and Y (shifts in
IS -LM Model Open Economy AD curve)

(Mundell–Fleming Model) • M-F model assumes small open economy with

perfect capital mobility (domestic interest rate (r) is
Exchange Rate Regimes determined by world interest rate(r*)
• Lesson from M-F model: behaviour of an economy
depends on its exchange rate system

Learning Objectives IS -LM model in Closed Economy

Y  C (Y  T )  I (r )  G r
• Mundell-Fleming model: Determination of Y LM
M P  L (r ,Y )
(IS-LM for a small open economy)
• Differential Interest rates: causes and effects Use IS-LM model to
of interest rate differentials (r and r*) analyze policy effects r1
• Exchange Rates: fixed vs. floating exchange • fiscal policy: G and/or T
rates • monetary policy: M IS
Y
• Aggregate Demand in Open Economy: Y1
derive AD curve for a small open economy

Mundell-Fleming Model National Income

(Open Economy Macroeconomics) in an open economy
• Key assumption:
Small open economy with perfect capital mobility.
Y = C + I + G + NX
so, r = r* (r* is world interest rate)
• Goods market equilibrium – the IS* curve: or, NX = Y – (C + I + G )
Y  C (Y  T )  I (r *)  G  NX (e )
domestic
Where, e = nominal exchange rate (NE)
spending
(e = foreign currency per unit domestic currency: (amount $ per Rupee)
net exports
RE = real exchange rate (E) = eP/P* (P* foreign price level) output
(RE = is relative prices of goods at home and abroad)
NX = net export depends (negatively) on real exchange rate (E).
here, e = E (because M-F model assumes P is fixed)

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Goods Market Equilibrium in M-F Model Derivation of IS* curve in

Open Economy
• There two financial variables affecting M-F model assumes P & P* are fixed
expenditure on goods & Services (r and e) - when ‘e’ appreciates,
- imports will cheaper & exports will costlier
• Simplifying it by assuming r=r* - fall in exports & rise in import - decline in NX

• Goods market equilibrium (IS*) in a small

open economy is

Y  C (Y  T )  I (r *)  G  NX (e )

The IS* curve (Open economy):

Interest Rate, Investment & IS curve
Goods market equilibrium
(Closed Economy) Y  C (Y  T )  I (r *)  G  NX (e )

The IS* curve is drawn e

for a given value of r*.
Intuition for the slope:

 e   NX   Y
IS*
Y

Deriving the LM curve: Derivation of LM* curve: in Open Economy

(Closed Economy)
(a) The market for 1. Closed Economy: Demand
(b) The LM curve
real money balances for Money (real money balance)
r r
M/P = L (r, Y)
LM
2.Open Economy: Demand
r2 r2 for Money (real money balance)
M/P = L (r*, Y)
L (r , Y2 )
r1 r1
L (r , Y1 ) ‘M’ - is exogenous and fixed,

M1 M/P Y1 Y2 Y ‘P’ - In short-run ‘P’ is fixed,

‘r’ - is adjusted with r* and constant
P So LM* will be vertical
M P  L (r ,Y ) Now LM* will determine only ‘Y’ regardless of exchange rate ‘e’
Because Exchange rate (e) does not enter into LM* equation

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The LM* curve (Open economy): Equilibrium in the Mundell-Fleming model

Money market equilibrium
M P  L (r *,Y ) Y  C (Y  T )  I (r *)  G  NX (e )
The LM* curve M P  L (r *,Y )
- is drawn for a given value of r*. e LM* e LM*
- is vertical because: Exogenous
Variable: G,T, M,
P, & r* equilibrium
for given r*, there is only one exchange
value of Y that equates money Endogenous rate
demand with supply, regardless Variables: Y & e
IS*
of exchange rate (e). Y equilibrium Y
level of
income

Economy under Different Exchange Rates Floating vs. fixed exchange rates
• In a system of floating exchange rates, ‘e’ is Argument for floating rates:
allowed to fluctuate in response to changing
– allows monetary policy to be used to pursue
economic conditions.
other goals (stable growth, low inflation).
• In contrast, under fixed exchange rates,
the central bank trades domestic currency for Arguments for fixed rates:
foreign currency at a predetermined price. – avoids uncertainty and volatility, making
• Let’s discuss impact of policy changes in an Open international transactions easier.
Economy that influence the equilibrium (e & Y) – disciplines monetary policy to prevent
– in a floating exchange rate system excessive money growth & hyperinflation.
– in a fixed exchange rate system

Lessons about Fiscal Policy

1. Fiscal policy: under floating exchange rates • In a small open economy with perfect capital mobility, fiscal
policy cannot affect real GDP (Y).
Y  C (Y  T )  I (r *)  G  NX (e )
• “Crowding out”
M P  L (r *,Y ) – closed economy:
e LM 1* Fiscal policy crowds out investment by causing the interest
At any given value of ‘e’, rate to rise.
e2
a fiscal expansion increases Y, – small open economy:
Or shifting IS* to the right. Fiscal policy crowds out net exports by causing the
e1
exchange rate to appreciate (or increase).
IS 2*
Note: any fiscal expansion (shift of IS curve)
Results: e > 0, Y = 0 IS 1* Closed economy: fiscal expansion (G, T) will raise ‘r’ if ‘M’ does not change
Y Small Open Economy:
Y1
1. r adjust with r* to be equal when there is shift of IS* - so ‘Y’ unchange
In Closed Economy Expansionary Fiscal Policy increases ‘Y’ as 2. if r > r* - inflows of foreign capital in to the country & foreign demand for
LM curve was upward sloping (IS-LM model) domestic currency to rises– it appreciates/rises ‘e’

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Effects of Expansionary Fiscal Policy in Expansionary Fiscal policy in Open

Open Economy Economy Macroeconomics
• Intuition for the shift in IS*: At a given value of e (and hence
NX), an increase in G causes an increase in Y that equates planned
expenditure with actual expenditure.
• How do we know that Y = 0?
• Because maintaining equilibrium in the money market
• Intuition for the results: requires that Y be unchanged:
• As we learned earlier, a fiscal expansion puts upward pressure on r. In
a small open economy with perfect capital mobility, as soon as the • the fiscal expansion does not affect either the real
domestic (r) rises, foreign (financial) capital will flow in to take money supply (M/P) or the world interest rate (because
advantage of the interest rate difference. this economy is “small”). Hence, any change in income
• Hence, the capital inflows cause an increase in foreign demand for would throw the money market out of whack.
domestic currency in the foreign exchange market, causing the
• So, the exchange rate has to rise until NX has fallen
domestic currency to appreciate (e).
enough to perfectly offset the expansionary impact of the
• This appreciation makes exports more expensive to foreigners, and
imports cheaper to people at home, and thus causes NX to fall. fiscal policy on output.
• The fall in NX due to appreciation of domestic currency or (e) offsets
the effect of the fiscal expansion on Y.

2. Monetary policy: (floating exchange rates)

Lessons about monetary policy
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y ) • Monetary policy affects output by affecting
the components of aggregate demand:
An increase in M shifts LM* e LM 1*LM 2* closed economy: M  r  I  Y
right because Y must rise to small open economy: M  e  NX  Y
restore eq’m in money market.
e1 • Expansionary monetary policy does not raise
Results: e < 0, Y > 0 aggregate demand (AD*), it merely shifts demand
e2
from foreign to domestic products.
IS 1*
Y So, the increases in domestic income and
Y1 Y2 employment are at the expense of losses abroad.
Closed Eco: Monetary transmission: Increase in M - reduces r - stimulate I and Y rises
Small Open Eco: since r = r* no monetary transmission is available.

Expansionary Monetary Policy in

(Open Economy) 3. Trade policy: floating exchange rates
• The model to determine the effects of an increase Y  C (Y  T )  I (r *)  G  NX (e )
in M on exchange rate e and on income Y.
M P  L (r *,Y )
• Intuition for the rightward LM* shift: e LM 1*
• At the initial (r*,Y), an increase in M throws the money market out of At any given value of e,
whack. To restore equilibrium, either Y must rise or the interest rate
a tariff or quota reduces imports, e2
must fall, or some combination of the two. In a small open economy,
though, the interest rate cannot fall. So Y must rise to restore increases NX,
equilibrium in the money market.
and shifts IS* to the right. e1
• Intuition for the final results: e < 0, Y > 0 IS 2*
• Initially, the increase in the M puts downward pressure on the r. (in a
closed economy, r would fall.) Because the economy is small and Results: IS 1*
open, when r falls below r*, capital will move from domestic market to Y
e > 0, Y = 0 Y1
the world financial market.
• This capital outflow causes the exchange rate e to fall, which causes How do we know that the effect of (e) appreciation on NX exactly
NX and hence Y to increase.
offsets/cancels out the effect of import restriction on NX?

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Effects of Protective Trade Policy in

(Open Economy)
Lessons about Trade Policy
• Intuition for results: e > 0, Y = 0 • Import restrictions cannot reduce a trade deficit.
• At given exchange rate e, the tariff or quota shifts • Even though NX is unchanged, there is less
domestic residents’ demand from foreign to domestic trade:
goods.
• The reduction in demand for foreign goods causes a
– the trade restriction reduces imports.
corresponding reduction in the supply of the country’s – the exchange rate appreciation reduces
currency in the foreign exchange market. exports.
• This causes the exchange rate e to rise. The domestic
currency appreciation reduces NX, offsetting the import
• Less trade means fewer “gains from
restriction’s initial expansion of NX. trade.”

Open Economy Macroeconomics

Fixed Exchange Rates
IS -LM Model • Under fixed exchange rates, the central bank
stands ready to buy or sell the domestic currency
for foreign currency at a predetermined rate.
• In the Mundell-Fleming model, the central bank
shifts the LM* curve as required to keep e at its
pre-announced rate.
(Mundell – Fleming Model) • This system fixes the nominal exchange rate.
Fixed Exchange Rate Regime In the long run, when prices P are flexible,
the real exchange rate can move even if the
nominal rate is fixed.
• In short-run nominal and real exchange rates are
almost same as P is not variable

1. Expansionary Fiscal Policy:

(fixed exchange rates)

Underfloating
Under floatingrates,
rates,
fiscal policy
a fiscal is ineffective
expansion e LM 1*LM 2*
atwould
changing
raiseoutput
e. or Y.
To keep e from rising,
Under fixed rates,
the central bank must
fiscal policy is very e1
sell domestic currency,
effective at changing
which increases M IS 2*
output.
and shifts LM* right. IS 1*
Results: Y
Y1 Y2
e = 0, Y > 0

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2. Expansionary Monetary Policy: Expansionary Monetary Policy:

(fixed exchange rates)
Under floating rates, • The monetary expansion puts downward pressure on the
e. To prevent it from falling, central bank starts buying
monetary policy is
An increase in M would domestic currency to “prop up” the value of the currency
very effective at changing in foreign exchange markets.
shift
output or Y. right and
LM* e LM 1*LM 2* • This buying removes domestic currency from circulation,
reduce
Under fixede.rates, causing the money supply to fall, which shifts the LM*
monetary policy cannot be curve back.
used to affect output.
e1 • Another way of looking at it: To keep the exchange rate
To prevent the fall in e, the fixed, the central bank must use monetary policy to shift
central bank must buy domestic LM* as required so that the intersection of LM* and IS*
IS 1* always occurs at the desired exchange rate.
currency, which reduces M and Y
Y1 • Unless the IS* curve shifts right (an experiment we are
shifts LM* back left.
not considering now), the central bank simply cannot
Results: e = 0, Y = 0 increase the money supply.

3. Protective Trade Policy: Summary of policy effects in the

(fixed exchange rates)
Open Economy (Mundell-Fleming model)
Under floating exchange rates,
A restriction
import restrictionson imports type of exchange rate regime:
doputs
not affect
upwardY orpressure
NX.
e LM 1*LM 2* floating fixed
Under e.fixede exchange
To keep
on from rising,rates,
import restrictions
the central bank must impact on:
increase Y and NX.
sell domestic currency, Policy changes Y e NX Y e NX
But, these
which gains come
increases M at the e1
expense of other countries:
and shifts LM* right. fiscal expansion 0    0 0
the policy merely shifts IS 2*
demand from foreign to IS 1* monetary
   0 0 0
domestic goods. Y expansion
Y1 Y2
import restriction 0  0  0 
Results: e = 0, Y > 0

Interest-Rate Differentials Differentials Interest Rate in M-F model

Two reasons why ‘r’ may differ from ‘r*’ r  r * 
– country risk: The risk that the country’s where  (Greek letter “theta”) is a risk
borrowers will default on their loan repayments
premium, assumed exogenous.
because of political or economic turmoil.
Lenders require a higher interest rate to Substitute the expression for r into the
compensate them for this risk. IS* and LM* equations:
– expected exchange rate changes: If a Y  C (Y  T )  I (r *   )  G  NX (e )
country’s exchange rate is expected to fall, then
its borrowers must pay a higher interest rate to M P  L (r *   ,Y )
compensate lenders for the expected currency
depreciation.

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The effects of an increase in  The effects of an increase in 

IS* shifts left, because • The fall in ‘e’ is intuitive:
An increase in country risk or an expected
  r  I e LM 1*LM 2* depreciation makes holding the country’s
LM* shifts right, because currency less attractive.
e1
  r  (M/P)d,
so Y must rise to restore • The increase in Y occurs because
money market eq’m. e2 IS 1* the boost in NX (from the depreciation)
IS 2*
Y is greater than the fall in I (from the rise in r ).
Y1 Y2
Results: e < 0, Y > 0

The impossible trinity The Impossible Trinity

A nation cannot have
Out of the 3 objectives free capital flows, Free capital
independent monetary flows
policy, and a fixed
• Free capital mobility exchange rate Option 1 Option 2
(U.S.) (Hong Kong)
• Exchange rate stability simultaneously.
• Monetary independence A nation must choose
one side of this
Independent Fixed
triangle and monetary
Option 3 exchange
policy makers can choose only 2 give up the policy
(China) rate
opposite
corner.

The Trilemma Choices in Asia Chapter Summary

Financial Exhange rate Monetary policy
openness* regime regime 1. Mundell-Fleming model
China 1 Managed Stability of val. of currency – the IS-LM model for a small open economy.
Hong Kong 0 Fixed Currency board – takes P as given.
India 1 Managed float Price stability and adequate
credit supply – can show how policies and shocks affect income
Indonesia 1 Managed float Inflation target 2005 and the exchange rate.
Korea 1 Float Inflation target 1998
Malaysia 1 Managed float Price stability/sustainable 2. Fiscal policy
growth
Phillipines 1 Managed float Inflation target 2002 – affects income under fixed exchange rates, but
Singapore 0 Managed Price stability not under floating exchange rates.
(intermediate target)
Thailand 1 Managed float Inflation target 2000

Note IMF Index 2005, 1= restrictions 0= no restrictions

Source: Hannoun (2007) and central bank webs

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Chapter Summary Chapter Summary

3. Monetary policy 5. Fixed vs. floating exchange rates
– affects income under floating exchange rates. – Under floating rates, monetary policy is available
– under fixed exchange rates, monetary policy is for can purposes other than maintaining exchange
not available to affect output. rate stability.
4. Interest rate differentials – Fixed exchange rates reduce some of the
uncertainty in international transactions.
– exist if investors require a risk premium to hold a
country’s assets.
– An increase in this risk premium raises domestic
interest rates and causes the country’s exchange
rate to depreciate.