The Open Economy and the

Mundell-Fleming Model

These notes expand the IS-LM model to an open economy to allow trade with other countries in
the model.

Balance of Payments
Measurement in international economics is centered around the concept of the Balance of Pay-
ments (BoP). The BoP is a kind of international balance sheet that measures the movement of
goods, services, and financial assets across countries. One side of the balance sheet, the current
account, measures the flow of goods and services, and the other, the capital account, measures
the flow of financial assets.

The Current Account (CA)

The current account can be further decomposed into three pieces

1. Net Exports (Exports - Imports)

2. Net Income (Domestic income from abroad - foreign income from home)
3. Current Transfers (Donations to or from other countries, foreign aid, etc.)

We will focus mainly on the first of these three components, so you can think of the current
account and net exports as being essentially the same.

The Capital Account (KA)

The capital account is sometimes broken into two pieces, the capital account and the financial
account. We will not make that distinction and instead say that the capital account can be
described as

KA = Change in foreign ownership of domestic assets−change in domestic ownership of foreign assets

Assets here is interpreted in a broad sense and can include ownership of businesses, stocks and
bonds (including government bonds), loans, and currency. It is important to draw a distinction
between ownership of assets, which counts in the capital account, and income from those assets,
which counts in the current account. So when a citizen from the US builds a factory in another
country, that counts as a change in domestic ownership of foreign assets (so a negative in the
capital account), but the profit they receive from that factory will count as net income (a positive
in the current account). Note the difference in the definition of capital here (financial capital)
and in the Solow model (physical capital).

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Balance of Payments
We define the balance of payments as

BoP = CA + KA
In theory, the balance of payments should always sum to zero. To see why, imagine a cit-
izen from Germany buys a computer that costs $100 from the United States. Obviously, this
transaction counts as an export for the United States (a positive in the current account) and an
import for Germany (a negative in the current account). But what about the capital account?
Since the German citizen needs to pay for the computer in United States currency (dollars), that
represents a decrease in foreign holdings of domestic assets (remember money is an asset) for
the US (a negative in the capital account) and a decrease in domestic holdings of foreign assets
for Germany (a positive in the capital account). The table below summarizes the effects of the
transaction

Current Account Capital Account BoP

United States +$100 (Computer Export) -$100 (Domestic Currency Inflow) 0
Germany -$100 (Computer Import) +$100 (Foreign Currency Outflow) 0

Of course, sometimes measurement of each of these items is hard so in reality the measured
BoP does not always sum to zero. Additionally, some measurements of the BoP do not include
foreign reserve holdings by the central bank in their measurements, which opens up another
wedge. For the purposes of this class, we will always assume the BoP is exactly equal to zero.

Exchange Rates
In order to compare economic data across countries we need to account for the fact that countries
use different currency. Exchange rates are the tool that make these comparisons possible

Nominal Exchange Rates

The nominal exchange rate refers to the price of one currency in terms of another. For this class,
we will always use the domestic country as the base unit. For example, from the perspective of
the US, the exchange rate with Japan will be in units of Yen/dollar. So if the going exchange
rate is 100 Yen to 1 US dollar, we will say the nominal exchange rate is 100 Yen/Dollar.

Real Exchange Rates

The nominal exchange rate is not always especially informative. What we really care about is
the amount of goods and services we can actually buy with money. With this motivation, we
define the real exchange rate as the price of one country’s goods in terms of another. Using the

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example from above, let’s assume for simplicity that Japan and the US each only produce 1 kind
of good. In the US it costs $5 and in Japan it costs 250 Yen. In order to buy one unit of the
good in the US, a Japanese citizen needs $5, so they could produce 2 units of the good and sell
them for 500 Yen. Then they could exchange these 500 Yen for $5 (with an exchange rate of 100
Yen/Dollar) and purchase one unit of the US good. We would then say that the real exchange
rate between the US and Japan is 2. More formally, we can define the real exchange rate as
PD
ε=e×
PF
Where ε is the real exchange rate, e is the nominal exchange rate, PD is the domestic price
level, and PF is the foreign price level. Note that the units of the nominal exchange rate are foreign
currency/domestic currency, and the units of the price level ratio are domestic currency/foreign
currency, which will cancel out and make the real exchange rate a unitless measure. When the
real exchange rate is high, domestic goods are relatively expensive when compared to foreign
goods. An easy way to see this result is to imagine the nominal exchange rate between the two
countries is 1. Then the real exchange rate is simply the ratio of the price levels in the two
countries.

The Foreign Exchange Market

In order to purchase goods or financial assets from any country, you would first need to purchase
that country’s currency. Other things equal, if a country has a very high exchange rate (i.e. it is
expensive to purchase its currency), then demand for its currency would be lower. Similarly, the
supply of a country’s currency depends on how much domestic citizens want to purchase goods
or financial assets from other countries. In this case, when the exchange rate is high, it means
that foreign currency is relatively cheap, so supply of domestic currency will be high. This logic
suggests a typical upward sloping supply curve and downward sloping demand.
e
S

D
Q

The y-axis shows the exchange rate in units of foreign currency per unit of domestic currency
and the x-axis shows the quantity of currency demanded or supplied. One important determinant
of demand for currency, which we will discuss below, is the relative rates of return on financial
assets in each country. We will assume that, other things equal, an increase in interest rates in
one country will cause an increase in demand for that country’s currency.

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The Mundell-Fleming Model
In this section, we will introduce a model quite similar to the IS-LM model we used to analyze the
closed economy called the Mundell-Fleming model (named after two economists, Robert Mundell
and Marcus Fleming, who developed the model concurrently in the 1960s). Essentially, the model
will allow us to examine the relationship between exchange rates and output in an open economy.
The Mundell-Fleming model builds directly on top of the standard IS-LM framework. All of
the same equations will carry over from that model but we need to make some adjustments to
incorporate open economy variables.

The BP Curve
First, we will add a brand new curve to the model. Assume that the current account only consists
of net exports and that demand for net exports depends on the amount of income a country has
(higher income countries will import more), and the real exchange rate (a higher real exchange
rate means the domestic currency has high purchasing power)
CA = N X = x − nY − mε
We can think of n here as the marginal propensity to import and m is the sensitivity of net exports
to the exchange rate. Next we will assume that the capital account depends on the difference
between the home country’s interest rate and the interest rate they could receive from the rest
of the world (which we will take as a constant)
KA = k + z(r − r∗ )
where r is the domestic interest rate, r∗ is the world interest rate, and the parameter z can be
interpreted as the degree of capital mobility that the country has with the rest of the world. If z
is high, then it is easier to move resources between countries and when there is a gap between
interest rates in the domestic and foreign countries, capital will flow towards countries with higher
rates (which also increases demand for those countries’ currencies). On the other hand, when z
is low, there are some costs or other frictions in moving capital between countries and a larger
gap can be sustained. In the extreme case with perfect capital mobility, z is infinite and the only
equilibrium will be when the home and foreign countries have exactly the same interest rate.
We can use these two equations to add a third line to our IS-LM model known as the BP
curve. This curve will represent all of the points where the balance of payments is equal to 0. To
derive this curve, note that we have
BoP = CA + KA = x − nY − mε + k + z(r − r∗ ) = 0
Solving this equation for r gives us
nY + mε − x − k
r = r∗ +
z
Recall that z is the level of capital mobility across countries. Here we can see more clearly that
as z gets large, the gap between the domestic interest rate and the foreign interest rate falls to
zero. To simplify the analysis, we will focus on the case where z is infinite. In this case, the BP
curve will be a horizontal line at the world interest rate r∗ .

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The IS and LM curves
The IS curve will still plot every point where the goods market is in equilibrium. Note that since
we are in an open economy, planned expenditure should include net exports, which depend on
the real exchange rate. As in the closed economy, we set Y = P E, but now P E includes NX
(using the same current account equation from above).
Y = C(Y, T ) + I P (r) + G + N X(ε)
A complete graph of the IS curve should really be in three dimensions as it depends on 3 variables
(Y, r, ε), but here we will draw a slice for a given real exchange rate and plot it only as a function
of r. This implies that changes in the exchange rate will shift the IS curve. Other things equal,
increases in the exchange rate will increase demand for imports and decrease demand for exports,
pushing NX down and shifting the IS curve left. Decreasing the exchange rate will have the
opposite effect, shifting the IS curve right.
On the monetary side of the economy, the LM curve is basically unaffected by the open
economy, although we will see that central bank policy can affect the exchange rate regime
below. For now, we will assume a standard upward sloping LM curve.

Putting the Model Together

We can plot the three curves described above - the new feature is the horizontal BP curve, fixed
at the world interest rate.
r
LM

r∗ BP

IS
Y
Y∗

The equilibrium of the model is when all three curves intersect. The adjustment mechanism
to get to equilibrium is a bit tricky here. Imagine that the IS and LM curve intersected below r∗ .
Then the domestic interest rate would be below the world interest rate and capital would flow
out of the country. However, this capital outflow would reduce demand for domestic currency
and put downward pressure on the exchange rate, shifting the IS curve to the right and restoring
equilibrium. Similar logic can be applied to the case where the domestic interest rate is above
the world interest rate.
The biggest difference between the open and closed economies will be the effects of fiscal
and monetary policy. We need to divide our discussion into two policy regimes, floating and fixed
exchange rates.

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Floating Exchange Rates
Note: Throughout this section I will assume the domestic country is the United States and will
therefore use dollars as shorthand for domestic currency.
When we say an exchange rate is “floating,” we mean that the central bank of our small open
economy will not do anything to intervene in exchange rate markets. They will allow the market
to decide what the rate should be.

Fiscal Policy with Floating Exchange Rates

Let’s consider the effect of a shift right in the IS curve (caused by an increase in government
spending for example).

r
LM

r∗ BP
IS2

IS1

Y
Y∗

When the IS curve shifts right, it puts pressure on the real interest rate to increase. However,
since the world interest rate stays fixed, this will cause capital inflow as investors try to take
advantage of high rates. Capital inflow increases demand for dollars and causes the real exchange
rate to rise. A higher real exchange rate shifts the IS curve left and this process will continue
until the IS curve is back to its original position and equilibrium is re-established.

r
LM

r∗ BP

IS3

Y
Y∗

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Monetary Policy with Floating Exchange Rates
Now let’s consider the effects of monetary policy. When the central bank increases the money
supply, LM shifts right

r
LM1 LM2

r∗ BP

IS1

Y
Y∗

This will put downward pressure on the interest rate, which means the domestic interest
rate is lower than interest rates in the rest of the world. As a result, foreign assets become
more attractive and capital will flow from the country into foreign countries. Demand for dollars
will fall, which decreases the real exchange rate, causing the IS curve to shift right and restore
equilibrium at the same interest rate but higher output.

r
LM1 LM2

r∗ BP
IS2

IS1

Y
Y1∗ Y2∗

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Fixed Exchange Rates
How Can a Central Bank Fix the Exchange Rate?
As we have seen above, exchange rates are determined by supply and demand for currency
In a fixed exchange rate regime, a central bank promises to buy and sell unlimited quantities
of currency at a fixed price. When the market exchange rate begins to rise above this fixed level,
arbitragers looking to make a profit can buy currency from the central bank and sell it to the
market, which increases the money supply and therefore causes a shift right in the LM curve. On
the other hand, when exchange rates begin to fall, arbitragers can make profit by buying from
the market and selling to the central bank, causing a decrease in the supply of domestic currency,
or a shift left in LM.
Before getting to policy effects with fixed exchanged rates, let’s think through a quick example
of how the central bank fixing an interest rate works. Imagine the Federal Reserve wants the
exchange rate between the US dollar and the Euro to be fixed at 1. Now assume that for some
reason demand for dollars increases (for example because interest rates in the US are rising and
people want to invest in the US). A higher demand for dollars would tend to push the price of
dollars (the exchange rate) up. However, if the exchange rate rises, that would open up a gap
between the market exchange rate (let’s say it rises to 1.1) and the fixed exchange rate offered
by the Fed (1). A profit seeking investor could then buy dollars from the Fed (i.e. exchange their
Euros for dollars at the Fed) and sell them to the market.
For example, with 100 Euros, you could afford to buy 100 dollars from the Fed. However,
each of these dollars can be exchanged for 110 in the market, so you could turn 100 Euros into
110 Euros purely by taking advantage of this gap (this kind of transaction is called arbitrage).
This transaction increases the supply of dollars in the economy, which is a shift right in the LM
curve. That shift right would then push down interest rates and restore the fixed exchange rate.
On the other side, if the exchange rate on the market fell (let’s say to 0.9), an investor could
sell dollars to the Fed (for example exchange 100 dollars for 100 Euros) and then sell these to
the market and get dollars in return (100 Euros is worth about 111 dollars at an exchange rate
of 0.9 Euros/Dollar)
Through this process, the money supply will automatically adjust to keep the exchange rate
fixed, which will move the LM curve automatically in response to economic shocks.
Let’s return to our policy analysis with the fixed exchange rate regime in mind.

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Fiscal Policy with Fixed Exchange Rates
For a shift in the IS curve, we saw that there would be upward pressure on interest rates, which
would cause capital inflow and higher exchange rates in the floating exchange rate regime.
r
LM

r∗ BP
IS2

IS1

Y
Y∗
However, in a fixed exchange rate regime, upward pressure on the exchange rate would cause
arbitragers to buy currency from the central bank and sell it to the market, causing the money
supply to increase and the LM curve to shift right.
r
LM1 LM2

r∗ BP
IS2

IS1

Y
Y1∗ Y2∗
So with fixed exchange rates, shifting the IS curve does have an impact on real GDP.

Monetary Policy with Fixed Exchange Rates

With fixed exchange rates, monetary policy can no longer work to change output. Consider an
increase in the money supply that shifts the LM curve right. A shift right in the LM curve will
again put downward pressure on exchange rates, which will causes arbitragers to buy from the
market and sell to the central bank. This decreases the money supply and shifts LM back to its
original position. In order to keep the exchange rate fixed, monetary needs to be solely focused
on that one goal. The central bank can no longer change the money supply with the goal of
keeping exchange rates fixed.

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Summary of Policy Effects
The table below summarizes the effects of policy changes on exchange rates and output in the
Mundell-Fleming model

Fixed Exchange Rates Floating Exchange Rates

Fiscal Policy Changes output only Changes exchange rates only
Monetary Policy No Effect Changes output and exchange rates

The Impossible Trinity (Trilemma)

The impossible trinity, or trilemma, is a result of the Mundell-Fleming model that says policy
makers can never accomplish the following three policies simultaneously:

1. Independent monetary policy

2. Fixed exchange rate

3. Free capital movement

At any time, the central bank can only commit to 2 out of these three policies. We saw above
that with full capital mobility and fixed exchange rates, the central bank can no longer influence
the economy by changing the money supply. If they want to have an impact, they either need to
allow the exchange rate to float or impose capital controls to prevent capital inflow and outflow
from affecting the exchange rate. For more on this, see the additional reading ”The Trilemma of
International Finance”

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