the Mundell–Fleming model,

small open economy with perfect capital

mobility.
• the interest rate in this economy r is determined by the world interest rate
r*.
• In a small open economy, the domestic interest rate might rise by a little bit
for a short time, but as soon as it did, foreigners would see the higher
interest rate and start lending to this country (by, for instance, buying this
country’s bonds). The capital inflow would drive the domestic interest rate
back toward r*.

• Similarly, if any event started to drive the domestic interest rate downward,
capital would flow out of the country to earn a higher return abroad, and
this capital outflow would drive the domestic interest rate back up to r*.
 The IS curve
• the goods market is represented with the following equation

• The Mundell–Fleming model, however, assumes that the price levels

at home and abroad are fixed, so the real exchange rate is
proportional to the nominal exchange rate.
• The goods-market equilibrium condition above has two financial
variables affecting expenditure on goods and services (the interest
rate and the exchange rate), but the situation can be simplified using
the assumption of perfect capital mobility, so r = r*. We obtain
 The LM Curve
• Once again, we add the assumption that the domestic interest rate
equals the world interest rate, so r = r*:

• The LM* curve is vertical because the exchange rate does not enter
into the LM* equation.
• According to the Mundell–Fleming model, a small open economy with
perfect capital mobility can be described by two equations
 Floating exchange rates.
• Fiscal Policy
• Notice that fiscal policy has very different effects in a small open
economy than it does in a closed economy
• Mechanically, the difference arises because the LM* curve is vertical,
while the LM curve we used to study a closed economy is upward
sloping.
• When income rises in a closed economy, the interest rate rises,
because higher income increases the demand for money.
• in a small open economy because, as soon as the interest rate starts
to rise above the world interest rate r*, capital quickly flows in from
abroad to take advantage of the higher return
• it also has another effect: because foreign investors need to buy the
domestic currency to invest in the domestic economy, the capital
inflow increases the demand for the domestic currency in the market
for foreign-currency exchange, bidding up the value of the domestic
currency.
• The appreciation of the domestic currency makes domestic goods
expensive relative to foreign goods, reducing net exports. The fall in
net exports exactly offsets the effects of the expansionary fiscal policy
on income
Monetary Expansion
• As soon as an increase in the money supply starts putting downward pressure on
the domestic interest rate, capital flows out of the economy, as investors seek a
higher return elsewhere.

• the capital outflow increases the supply of the domestic currency in the market for
foreign currency exchange, causing the domestic currency to depreciate in value.

• This depreciation makes domestic goods inexpensive relative to foreign goods,

stimulating net exports and thus total income. Hence, in a small open economy,
monetary policy influences income by altering the exchange rate rather than the
interest rate
 Trade Policy
• a reduction in imports means an increase in net exports.
• the net-exports schedule increases planned expenditure and thus moves the IS* curve to
the right. Because the LM* curve is vertical, the trade restriction raises the exchange rate
but does not affect income
• Because net exports are a component of GDP, the rightward shift in the net-exports
schedule, other things equal, puts upward pressure on income Y; an increase in Y, in turn,
increases money demand and puts upward pressure on the interest rate r.
• Foreign capital quickly responds by flowing into the domestic economy, pushing the
interest rate back to the world interest rate r* and causing the domestic currency to
appreciate in value.
• Finally, the appreciation of the currency makes domestic goods more expensive relative
to foreign goods, which decreases net exports NX and returns income Y to its initial level.
 Fixed exchange rates
• A fixed exchange rate dedicates a country’s monetary policy to the
single goal of keeping the exchange rate at the announced level.
 Fiscal Policy
• under a fixed exchange rate, a fiscal expansion raises aggregate
income.
• Expansionary fiscal policy shifts the IS*curve to the right, putting
upward pressure on the market exchange rate.
• arbitrageurs quickly respond to the rising exchange rate by selling
foreign currency to the central bank, leading to an automatic
monetary expansion.
• The rise in the money supply shifts the LM* curve to the right.
 Monetary Policy
• monetary policy as usually conducted is ineffectual under a fixed
exchange rate. By agreeing to fix the exchange rate, the central bank
gives up its control over the money supply.
• The initial impact of expansionary monetary policy is to shift the LM*
curve to the right, lowering the exchange rate.
• arbitrageurs quickly respond to the falling exchange rate by selling the
domestic currency to the central bank, causing the money supply and
the LM* curve to return to their initial positions.
 Trade Policy
• Government reduces imports by imposing an import quota or a tariff.
• This policy shifts the net-exports schedule to the right and thus shifts
the IS* curve to the right.
• The shift in the IS* curve tends to raise the exchange rate. To keep the
exchange rate at the fixed level, the money supply must rise, shifting
the LM* curve to the right.
• The reason is that a trade restriction under a fixed exchange rate
induces monetary expansion rather than an appreciation of the
currency. The monetary expansion, in turn, raises aggregate income.
• When investors buy U.S. government bonds or make loans to U.S. corporations,
they are fairly confident that they will be repaid with interest. By contrast, in
some less-developed countries, it is plausible to fear that a revolution or other
political upheaval might lead to a default on loan repayments.
• Borrowers in such countries often have to pay higher interest rates to
compensate lenders for this risk.
• Another reason interest rates differ across countries is expected changes in the
exchange rate.
• Thus, because of both country risk and expectations of future exchange-rate
changes, the interest rate of a small open economy can differ from interest
rates in other economies around the world
 Differentials
• To incorporate interest rate differentials into the Mundell–Fleming
model, we assume that the interest rate in our small open economy is
determined by the world interest rate plus a risk premium:
• Now suppose that political turmoil causes the country’s risk premium v
to rise.
• Because r = r* + v, the most direct effect is that the domestic interest
rate r rises. The higher interest rate, in turn, has two effects.
• First, the IS* curve shift to the left, because the higher interest rate
reduces investment.
• Second, the LM* curve shifts to the right, because the higher interest
rate reduces the demand for money, and this allows a higher level of
income for any given money supply.
• these two shifts cause income to rise and the currency to depreciate.
• There are three reasons why, in practice, such a boom in income does not occur.
• First, the central bank might want to avoid the large depreciation of the domestic
currency and, therefore, may respond by decreasing the money supply M.
• Second, the depreciation of the domestic currency may suddenly increase the
price of imported goods, causing an increase in the price level P.
• Third, when some event increases the country risk premium v, residents of the
country might respond to the same event by increasing their demand for money
(for any given income and interest rate), because money is often the safest asset
available.
• All three of these changes would tend to shift the LM* curve toward the left,
which mitigates the fall in the exchange rate but also tends to depress income.
Long Run
• point K describes the short run equilibrium, because it assumes a fixed price
level.
• At this equilibrium, the demand for goods and services is too low to keep
the economy producing at its natural level. Over time, low demand causes
the price level to fall. The fall in the price level raises real money balances,
shifting the LM* curve to the right.
• The real exchange rate depreciates, so net exports rise. Eventually, the
economy reaches point C, the long-run equilibrium.
• The speed of transition between the short-run and long-run equilibria
depends on how quickly the price level adjusts to restore the economy to
the natural level of output.