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| The '''Mundell–Fleming model''', also known as the '''IS-LM-BoP model''', is an [[economics|economic]] model first set forth (independently) by [[Robert Mundell]] and [[Marcus Fleming]].<ref name="Mundell">{{Cite journal |last=Mundell |first=Robert A. |year=1963 |title=Capital mobility and stabilization policy under fixed and flexible exchange rates |journal=Canadian Journal of Economic and Political Science |volume=29 |issue=4 |pages=475–485 |doi=10.2307/139336 }} Reprinted in {{Cite book |last=Mundell |first=Robert A. |year=1968 |title=International Economics |location=New York |publisher=Macmillan |isbn= }}</ref><ref name="Fleming">{{Cite journal |last=Fleming |first=J. Marcus |year=1962 |title=Domestic financial policies under fixed and floating exchange rates |journal=IMF Staff Papers |volume=9 |issue= |pages=369–379 |doi= }} Reprinted in {{Cite book |editor-last=Cooper |editor-first=Richard N. |year=1969 |title=International Finance |location=New York |publisher=Penguin Books |isbn= }}</ref> The model is an extension of the [[IS-LM model|'''IS-LM''' Model]]. Whereas the traditional '''IS-LM''' Model deals with economy under [[autarky]] (or a closed economy), the Mundell–Fleming model describes an open economy.
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| The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy '''IS-LM''' model, which focuses only on the relationship between the interest rate and output). The Mundell–Fleming model has been used to argue that an economy cannot simultaneously maintain a [[fixed exchange rate]], [[free movement of capital and payments|free capital movement]], and an independent [[monetary policy]]. This principle is frequently called the "[[impossible trinity]]," "unholy trinity," "irreconcilable trinity," "inconsistent trinity" or the "Mundell–Fleming [[trilemma]]."
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| ==Basic set up==
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| ===Variables===
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| This model uses the following variables:
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| * ''Y'' is [[GDP]]
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| * ''C'' is [[Consumption (economics)|consumption]]
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| * ''I'' is [[fixed investment|physical investment]]
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| * ''G'' is [[government spending]] (an [[exogenous variable]])
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| * ''M'' is the nominal [[money supply]]
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| * ''P'' is the [[price level]]
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| * ''i'' is the nominal [[interest rate]]
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| * ''L'' is liquidity preference (real [[money demand]])
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| * ''T'' is [[taxes]]
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| ===Equations===
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| The Mundell–Fleming model is based on the following equations.
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| The '''IS''' curve:
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| :<math>Y=C+I+G+NX \, </math>
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| where ''NX'' is net [[exports]].
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| The '''LM''' curve:
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| :<math>\frac{M}{P}=L(i, Y)</math>
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| A higher interest rate or a lower income (GDP) level leads to lower money demand.
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| The '''BoP''' (Balance of Payments) Curve:
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| :<math>BoP=CA+KA \, </math>
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| where '''BoP''' is the [[balance of payments]] surplus, ''CA'' is the [[current account]] surplus, and ''KA'' is the [[capital account]] surplus.
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| ===IS components===
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| :<math>C=C (Y-T(Y), i-E( \pi )) \, </math>
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| where ''E''(π) is the expected rate of [[inflation]]. Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending.
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| :<math>I=I(i-E(\pi), Y_{-1}) \, </math>
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| where ''Y''<sub>-1</sub> is GDP in the previous period. Higher lagged income or a lower real interest rate leads to higher investment spending.
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| :<math>NX=NX (e, Y, Y*)</math>
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| where ''NX'' is [[net exports]], ''e'' is the nominal [[exchange rate]] (the price of domestic currency in terms of units of the foreign currency), ''Y'' is GDP, and ''Y*'' is the combined GDP of countries that are foreign trading partners. Higher domestic income (GDP) leads to more spending on imports and hence lower net exports; higher foreign income leads to higher spending by foreigners on the country's exports and thus higher net exports. A higher ''e''leads to higher net exports.
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| ===Balance of payments (BoP) components===
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| *<math>CA=NX</math>
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| **where ''CA'' is the current account and ''NX'' is net exports. That is, the current account is viewed as consisting solely of imports and exports.
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| *<math>KA=z(i-i*)+k</math>
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| **where <math>i*</math> is the foreign interest rate, ''k'' is the exogenous component of financial capital flows, ''z'' is the interest-sensitive component of capital flows, and the derivative of the function ''z'' is the degree of capital mobility (the effect of differences between domestic and foreign interest rates upon capital flows ''KA'').
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| ===Variables determined by the model===
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| After the subsequent equations are substituted into the first three equations above, one has a system of three equations in three unknowns, two of which are GDP and the domestic interest rate. Under [[Exchange rate flexibility|flexible exchange rate]]s, the exchange rate is the third [[Endogeny#Economics and finance|endogenous variable]] while '''BoP''' is set equal to zero. In contrast, under [[fixed exchange rate]]s ''e'' is exogenous and the balance of payments surplus is determined by the model.
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| Under both types of exchange rate regime, the nominal domestic money supply ''M'' is exogenous, but for different reasons. Under flexible exchange rates, the nominal money supply is completely under the control of the central bank. But under fixed exchange rates, the money supply in the short run (at a given point in time) is fixed based on past international money flows, while as the economy evolves over time these international flows cause future points in time to inherit higher or lower (but pre-determined) values of the money supply.
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| ==Mechanics of the model==
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| The model's workings can be described in terms of an '''IS-LM-BoP''' graph with the domestic interest rate plotted vertically and real GDP plotted horizontally. The '''IS''' curve is downward sloped and the '''LM''' curve is upward sloped, as in the closed economy '''IS-LM''' analysis; the '''BoP''' curve is upward sloped unless there is perfect capital mobility, in which case it is horizontal at the level of the world interest rate.
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| In this graph, under less than perfect capital mobility the positions of both the '''IS''' curve and the '''BoP''' curve depend on the exchange rate (as discussed below), since the '''IS-LM''' graph is actually a two-dimensional [[cross-section (geometry)|cross-section]] of a three-dimensional space involving all of the interest rate, income, and the exchange rate. However, under perfect capital mobility the '''BoP''' curve is simply horizontal at a level of the domestic interest rate equal to the level of the world interest rate.
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| ===Under a flexible exchange rate regime===
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| In a system of flexible exchange rates, central banks allow the exchange rate to be determined by market forces alone.
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| ==== Changes in the money supply ====
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| An increase in money supply shifts the '''LM''' curve to the right. This directly reduces the local interest rate relative to the global interest rate.A decrease in the money supply causes the exact opposite process.
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| ==== Changes in government spending ====
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| An increase in government expenditure shifts the '''IS''' curve to the right. The shift causes both the local interest rate and income (GDP) to rise.A decrease in government expenditure reverses the process.
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| ==== Changes in the global interest rate ====
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| An increase in the global interest rate shifts the '''BoP''' curve upward and causes capital flows out of the local economy. This depreciates the local currency and boosts net exports, shifting the '''IS''' curve to the right. Under less than perfect capital mobility, the depreciated exchange rate shifts the '''BoP''' curve somewhat back down.Under perfect capital mobility, the '''BoP''' curve is always horizontal at the level of the world interest rate. When the latter goes up, the '''BoP''' curve shifts upward by the same amount, and stays there. The exchange rate changes enough to shift the '''IS''' curve to the location where it crosses the new '''BoP''' curve at its intersection with the unchanged '''LM''' curve; now the domestic interest rate equals the new level of the global interest rate.
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| A decrease in the global interest rate causes the reverse to occur.
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| ===Under a fixed exchange rate regime===
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| In a system of fixed exchange rates, central banks announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency. Thus net payments flows into or out of the country need not equal zero; the exchange rate ''e'' is exogenously given, while the variable '''BoP''' is endogenous.
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| Under the fixed exchange rate system, the central bank operates in the [[foreign exchange market]] to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currency's supply in the foreign exchange market. This keeps the domestic currency's exchange rate at its targeted level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in the foreign exchange market. Again,this keeps the exchange rate at its targeted level.
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| ==== Changes in the money supply ====
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| In the very short run the money supply is normally predetermined by the past history of international payments flows. If the central bank is maintaining an exchange rate that is consistent with a balance of payments surplus, over time money will flow into the country and the money supply will rise (and vice versa for a payments deficit). If the central bank were to conduct open market operations in the domestic bond market in order to offset these balance-of-payments-induced changes in the money supply — a process called [[sterilization (economics)|sterilization]], it would absorb newly arrived money by decreasing its holdings of domestic bonds (or the opposite if money were flowing out of the country). But under perfect capital mobility, any such sterilization would be met by further offsetting international flows.
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| ==== Changes in government expenditure ====
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| [[File:Mundell-Fleming example fixed exchange rate .png|thumb|250px|right|An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the '''BoP''' curve (or, as denoted here, the FE curve) is horizontal.]]
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| Increased government expenditure shifts the '''IS''' curve to the right. The shift results in an incipient rise in the interest rate, and hence upward pressure on the exchange rate (value of the domestic currency) as foreign funds start to flow in, attracted by the higher interest rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed exchange rate system. To maintain the exchange rate and eliminate pressure on it, the monetary authority purchases foreign currency using domestic funds in order to shift the '''LM''' curve to the right. In the end, the interest rate stays the same but the general income in the economy increases. In the '''IS-LM-BoP''' graph, the '''IS''' curve has been shifted exogenously by the fiscal authority, and the '''IS''' and '''BoP''' curves determine the final resting place of the system; the '''LM''' curve merely passively reacts.
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| The reverse process applies when government expenditure decreases.
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| ==== Changes in the global interest rate ====
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| To maintain the fixed exchange rate, the central bank must accommodate the capital flows (in or out) which are caused by a change of the global interest rate, in order to offset pressure on the exchange rate.
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| If the global interest rate increases, shifting the '''BoP''' curve upward, capital flows out to take advantage of the opportunity. This puts pressure on the home currency to depreciate, so the central bank must buy the home currency — that is, sell some of its foreign currency reserves — to accommodate this outflow. The decrease in the money supply resulting from the outflow, shifts the '''LM''' curve to the left until it intersect the '''IS''' and '''BoP''' curves at their intersection. Once again, the '''LM''' curve plays a passive role, and the outcomes are determined by the '''IS-BoP''' interaction.
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| Under perfect capital mobility, the new '''BoP''' curve will be horizontal at the new world interest rate, so the equilibrium domestic interest rate will equal the world interest rate.
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| If the global interest rate declines below the domestic rate, the opposite occurs. The '''BoP''' curve shifts down, foreign money flows in and the home currency is pressured to appreciate, so the central bank offsets the pressure by selling domestic currency (equivalently, buying foreign currency). The inflow of money causes the '''LM''' curve to shift to the right, and the domestic interest rate becomes lower (as low as the world interest rate if there is perfect capital mobility).
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| ==Differences from IS-LM==
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| It is worth noting that some of the results from this model differ from those of the '''IS-LM''' model because of the [[open economy]] assumption. Results for a large open economy, on the other hand, can be consistent with those predicted by the '''IS-LM''' model. The reason is that a large open economy has the characteristics of both an autarky and a small open economy. In particular, it may not face perfect capital mobility, thus allowing internal policy measures to affect the domestic interest rate, and it may be able to sterilize balance-of-payments-induced changes in the money supply (as discussed above).
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| In the '''IS-LM''' model, the domestic interest rate is a key component in keeping both the money market and the goods market in equilibrium. Under the Mundell–Fleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply (by international funds flows).
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| ===Example===
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| The Mundell–Fleming model applied to a small open economy facing perfect capital mobility, in which the domestic interest rate is exogenously determined by the world interest rate, shows stark differences from the closed economy model.
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| Consider an exogenous increase in government expenditure. Under the '''IS-LM''' model, the '''IS''' curve shifts upward, with the '''LM''' curve intact, causing the interest rate and output to rise. But for a small open economy with perfect capital mobility and a flexible exchange rate, the domestic interest rate is predetermined by the horizontal '''BoP''' curve, and so by the '''LM''' equation given previously there is exactly one level of output that can make the money market be in equilibrium at that interest rate. Any exogenous changes affecting the '''IS''' curve (such as government spending changes) will be exactly offset by resulting exchange rate changes, and the '''IS''' curve will end up in its original position, still intersecting the '''LM''' and '''BoP''' curves at their intersection point.
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| The Mundell–Fleming model under a fixed exchange rate regime also has completely different implications from those of the closed economy '''IS-LM''' model. In the closed economy model, if the central bank expands the money supply the '''LM''' curve shifts out, and as a result income goes up and the domestic interest rate goes down. But in the Mundell–Fleming open economy model with perfect capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an incipient outward shift of the '''LM''' curve would make capital flow out of the economy. The central bank under a fixed exchange rate system would have to instantaneously intervene by selling foreign money in exchange for domestic money to maintain the exchange rate. The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the '''LM''' curve to shift to the right, and the interest rate remains equal to the world rate of interest.
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| ==See also==
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| *[[Optimum currency area]]
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| ==References==
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| {{Reflist}}
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| ==Further reading==
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| *{{Citation |last=Young |first=Warren |last2=Darity |first2=William, Jr. |authorlink2=Sandy Darity, Jr. |year=2004 |title=IS-LM-BP: An Inquest |journal=History of Political Economy |volume=36 |issue=Suppl 1 |pages=127–164 |url=http://www.econ.ucdavis.edu/faculty/kdhoover/pdf/Hope/Young.pdf |doi=10.1215/00182702-36-Suppl_1-127 }} <small>(Tells the difference between the IS-LM-BP model and the Mundell–Fleming model.)</small>
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| *{{citation |last=Carlin |first=Wendy |last2=Soskice |first2=David W. |title=Macroeconomics and the Wage Bargain |year=1990 |publisher=Oxford University Press |location=New York |isbn=0-19-877245-9 }}
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| *{{citation |last=Mankiw |first=N. Gregory |authorlink=N. Gregory Mankiw |title=Macroeconomics |year=2007 |edition=6th |publisher=Worth |location=New York |isbn=978-0-7167-6213-3 }}
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| *{{citation |last=Blanchard |first=Olivier |title=Macroeconomics |year=2006 |publisher=Prentice Hall |location=Upper Saddle River, NJ |edition=4th |isbn=0-13-186026-7 }}
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| *{{citation |last=DeGrauwe |first=Paul |title=Economics of Monetary Union |year=2000 |publisher=Oxford University Press |location=New York |edition=4th |isbn=0-19-877632-2 }}
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| {{Macroeconomics}}
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| {{DEFAULTSORT:Mundell-Fleming model}}
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| [[Category:Economics models]]
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| [[Category:International economics]]
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| [[Category:Open economy macroeconomics]]
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| [[Category:Macroeconomics]]
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