8. Mundell-Fleming Model with a Floating Exchange Rate
(No handout; chapter 13)
What is the Mundell-Fleming model?
In an open economy with external trade and financial transactions, how are the key macrovariables (GDP, inflation, balance of payments, exchange rates, interest rates, etc) determined and interact with each other? What are the effects of fiscal and monetary policies? The Mundell-Fleming model is the standard open macroeconomic model that tries to answer these questions. Most open macro economy models in the textbooks are variations of the Mundell-Fleming model.
Theoretically, it is the most popular model. But its applicability to actual policy making is not as high as we would hope (especially for developing and transition…show more content… It is downward-sloping in the (i, Y) plane. Moreover, a rise in q (real depreciation) or a rise in G (government spending) shifts the IS curve up and to the right.
Aggregate demand - LM curve
The LM curve is the same as in the domestic macro version. It shows the condition for money market equilibrium.
In particular, we ignore the possibility of "currency substitution," a phenomenon where domestic citizens hold foreign currency (typically US dollar) as well as domestic currency, and change their relative shares as circumstances change. No currency substitution is a reasonable assumption in developed countries, where people hold only domestic currency. But in many developing countries, currency substitution may be a big factor that influences the money demand.
Currency substitution is also called "dollarization." But dollarization has two meanings: (1) the situation where people use dollars in addition to domestic currency, because they do not trust the latter (in this case, the monetary authority usually tries to prevent the use of dollar); (2) the situation where the government declares that the national currency is the US dollar, abolishes the central bank, and gives up independent monetary policy. Currency substitution is equivalent