§15 The Mundell-Fleming Model

The Mundell-Fleming Model

• Equilibrium in the Goods Market in the Open Economy can be written as:

  $$Y = C(Y - T) + I(Y, r) + G + NX(Y, Y^*, \epsilon)$$

  with

  $$NX_Y < 0, NX_{Y^*} > 0, NX_\epsilon < 0$$

• If we assume domestic and foreign prices are fixed (which we will do), then we can write it as:

  $$Y = C(Y - T) + I(Y, i) + G + NX(Y, Y^*, E)$$

• Equilibrium in Financial Markets in the Open Economy is captured by the interest parity condition:

  $$E_t = \frac{1 + i_t}{1 + i^*_t} E^{e}_{t+1}$$

• We will take as given $E^{e}_{t+1} = E^{e}$ , and write the current exchange rate as:

  $$E = \frac{1 + i}{1 + i^*} E^{e}$$

• An increase in the domestic interest rate (other things equal), appreciates the exchange rate.

• An increase in the foreign interest rate (other things equal), depreciates the exchange rate.

• An expected increase in the future exchange rate (other things equal), appreciates the exchange rate today.

Goods and Financial Markets Together

• The IS in the Open Economy

  $$\begin{aligned} Y &= C(Y - T) + I(Y, i) + G + NX(Y, Y^*, E) \\ &= C(Y - T) + I(Y, i) + G + NX\left(Y, Y^*, \frac{1+i}{1+i^*}E^{e}\right) \tag{IS} \end{aligned}$$

• The LM (same as in the closed economy)

  $$i = \bar{i} \tag{LM}$$

— Apr 23, 2025

§15 The Mundell-Fleming Model by Lu Meng is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. Permissions beyond the scope of this license may be available at About.