# Mundell-Fleming model

The **Mundell-Fleming model** is a working model of economics . It was developed independently by Robert Mundell and Marcus Fleming and, in contrast to the IS-LM model, describes open , non- closed economies .

## Basic model

The model describes a small economy that is connected to other countries through trade and cross-border capital flows, and shows which policy options exist and how the country reacts to changes in internal and external framework conditions.

For this reason there is a third curve in addition to the IS curve , which shows the location of all equilibria in the goods market , and the LM curve , which shows all equilibria in the money market : the ZZ curve , sometimes also called FE Called curve. This curve represents all balance of payments balances of zero; H. all interest - income combinations in which external contributions and net capital exports add up to zero.

The ZZ curve is described by the following equation (assuming complete free movement of capital):

,

where represents the interest rate, the (nominal) exchange rate at the time and the exchange rate expected for the following period.

In the equilibria of the national economy, a distinction must now be made between a domestic, an external and an overall economic balance. The point of intersection between the IS and LM curves is referred to as the domestic economic equilibrium; the external economic equilibrium is represented by the ZZ curve. An economy is only in macroeconomic equilibrium if the internal equilibrium lies on the ZZ curve. This must therefore run through the intersection of the IS and LM curves.

## Comparative statics

With the help of the Mundell-Fleming model, the behavior of interest rates and output due to expansionary (or contractive) fiscal or monetary policy can be seen, both in the case of flexible and fixed exchange rates. In the following, complete capital mobility is always assumed.

- Expansive fiscal policy

- Flexible exchange rates: The IS curve is initially shifting to the right due to the increased government spending (yes , the associated output is higher for each ). The new intersection between the IS and LM curves results in a higher interest rate than foreign investors would ask. This triggers an unlimited inflow of capital from abroad, which increases the demand for the domestic currency. As a result, the domestic currency appreciates. Assuming that the Marshall-Lerner condition is met, this leads to a decline in the exchange rate, which causes a decline in the trade balance and exports. There is thus again a lower output . This is shown graphically by the fact that the IS curve shifts back to the left over time to its original position. Thus, the effect of the expansive fiscal policy is suppressed by a total appreciation-related crowding-out, expansive fiscal policy is ineffective in the case of complete capital mobility. However, if one abandons the assumption of complete capital mobility, there is definitely a positive effect with flexible exchange rates. In the case of high capital mobility, the new equilibrium after the expansionary fiscal policy will lead to the already known currency appreciation again, but the effect is not so strong that it causes complete crowding-out. In the case of low capital mobility, i.e. a steep ZZ curve, the new equilibrium leads to an inflow of foreign capital, this leads to a devaluation of the domestic currency and the positive effect of the expansionary fiscal policy increases.
- Fixed exchange rates: The IS curve is initially shifting to the right due to the increased government spending (yes , the corresponding output is higher for each ). The new intersection between the IS and LM curves entails a higher interest rate . This triggers an unlimited inflow of capital from abroad, which increases the demand for the domestic currency. As a result, the value of the domestic currency increases relative to the foreign one, but this should be prevented by the central bank in a fixed exchange rate regime. It does this by expanding the amount of money and thus lowering the interest rate, as long as the domestic interest rate is above the foreign interest rate - the LM curve thus shifts downwards until a state of equilibrium is restored. In this equilibrium, the interest is now the same as before, since it must always correspond to the foreign interest. However, the increase in was not compensated for.

It follows that expansionary fiscal policy is effective in a fixed exchange rate regime, but ineffective in a flexible regime.

- Expansive monetary policy

- Flexible exchange rates: is now lower than before due to the increase in the money supply (or the increase in money supply is realized by a lower one ), so that the LM curve shifts downwards. This implies a higher output , since investments increase due to the lower interest rate ( ). The new intersection of the IS and LM curves is therefore below the ZZ curve. This is because a lower interest rate induces a capital outflow, as investors then prefer investments abroad. This increases the demand for foreign currency (and decreases that for the domestic currency). This creates a devaluation pressure on the home currency. A devaluation of the domestic currency induces an increase in exports (or a decrease in imports) and thus a shift to the right of the IS curve (i.e. another increase in ). At the end of the chain of effects, the intersection of the new IS curve and the new LM curve (domestic economic equilibrium) is again on the ZZ curve (external economic equilibrium).
- Fixed exchange rates: is now lower than before due to the increase in the money supply (or the increase in money supply is realized by a lower one ), so that the LM curve shifts downwards. This implies a higher output . The new intersection of the IS and LM curves is therefore below the ZZ curve. This is because a lower interest rate induces a capital outflow, as investors then prefer investments abroad. This increases the demand for foreign currency (and decreases that for the domestic currency). This creates pressure to devalue the home currency, which in a fixed exchange rate regime should be prevented by the central bank. It controls against it by reversing the (expected) price increase of the foreign currency through a corresponding sale of foreign currency (foreign exchange). When the foreign exchange is sold, the central bank accepts its own currency and thus reduces the amount of its own currency in circulation. However, this just indicates an upward shift in the LM curve, so that ultimately the entire measure is revised again.

It follows that expansionary monetary policy is effective in a flexible exchange rate regime, but ineffective in a fixed regime.

## Model extension

A further development is the two-country Mundell-Fleming model, in which large countries and their effects on the “rest of the world” are also modeled.

The AD curve is derived from the Mundell-Fleming model .

## literature

- Marcus Fleming:
*Domestic financial policies under fixed and floating exchange rates.*IMF Staff Papers 9, 1962, pp. 369-379. - Robert Mundell:
*Capital mobility and stabilization policy under fixed and flexible exchange rates.*In:*Canadian Journal of Economic and Political Science.*Vol. 29, 1962, pp. 475-485.