Module 12 · Chapters 20

Mundell–Fleming

Open-economy IS-LM under fixed vs flexible exchange rates.

“Why fiscal works under fixed FX, monetary works under floating, and you can't have both.”

~40 min· 4 sub-skills·6 exercisesExam frequency · high0% mastered

Mundell-Fleming extends IS-LM to a small open economy with perfect capital mobility. The result is the cleanest comparative-statics demonstration in macro: the same fiscal expansion has opposite output implications depending on whether the exchange rate is fixed or floating.
Uncovered interest parity (UIP)
$i \;=\; i^* + \frac{E^e_{t+1} - E_t}{E_t}$
$i$
domestic interest rate
$i^*$
foreign interest rate
$E^e_{t+1}$
expected next-period FX
Free capital flows arbitrage rate differentials away. Higher domestic i requires expected currency depreciation.
Definition·Fixed exchange rate regime
E pinned by the CB. Implication: i must equal i (UIP with E^e = E). Domestic CB has no monetary autonomy* — it must defend the peg.

- Fiscal expansion: powerful. ΔG raises Y; the CB has to print money to prevent appreciation; M^s rises endogenously; rate stays at i*. No crowding out.
- Monetary expansion: zero. Lowering i would force depreciation; CB can't allow it; reverses immediately.
Definition·Flexible exchange rate regime
E moves freely; CB sets i.

- Fiscal expansion: weakened. ΔG raises Y, raises i, attracts capital, appreciates currency, NX falls — partial offset.
- Monetary expansion: amplified. ΔM lowers i, capital flees, currency depreciates, NX rises — fiscal-like effect via FX channel.
Figure · Mundell-Fleming response
Loading Mundell-Fleming…
Fiscal vs monetary, fixed vs floating — the four canonical regimes.
Insight·The Impossible Trinity
You can pick any two of: free capital mobility, fixed exchange rate, independent monetary policy. Never all three.
- USA: free capital + flexible FX → independent CB. ✓
- China (historic): free capital + monetary autonomy ⇒ accept FX flex. (Or peg + autonomy ⇒ capital controls.)
- Eurozone: fixed (within EU) + free capital → no national monetary policy. ✓
Common misconception
Under flexible FX, fiscal policy has no effect on Y.
ActuallyFiscal policy is **dampened** but not zero. The FX appreciation crowds out NX partially; Y still rises in the short run.
Exercise · numerical · +12 XP
UIP arithmetic
i = 5%, i* = 3%, E_t = 1.10. UIP holds. What is E^e_{t+1}?
Your answer
Exercise · predict shift · +12 XP
Fiscal under fixed
Small open economy, fixed FX. ΔG > 0.
Scenario: Fixed FX, perfect capital mobility, ΔG = +100.
Exercise · true false · +10 XP
Monetary under fixed
Under a credibly-fixed exchange rate, the CB cannot independently lower i to stimulate output.
"Under a credibly-fixed exchange rate, the CB cannot independently lower i to stimulate output."
Exercise · predict shift · +12 XP
Fiscal under flexible
Small open economy, flexible FX. ΔG > 0.
Scenario: Flexible FX, perfect capital mobility, ΔG = +100.
Exercise · predict shift · +12 XP
Monetary under flexible
Small open economy, flexible FX. CB cuts i.
Scenario: Flexible FX, perfect capital mobility, ΔiᵀT = −0.02.
Exercise · multiple choice · +10 XP
Impossible trinity case
China historically maintained a managed FX peg with capital controls. According to the trinity, China was choosing:

Mastery check

5 questions · pass with 80%

Answer all five to confirm you've internalised the module. A passing run unlocks the next module.

Q1
Fiscal expansion is most powerful under:
Q2
Monetary policy is most powerful under:
Q3
Eurozone members give up which corner of the trinity?
Q4
"If domestic i > i*, UIP requires markets to expect domestic currency depreciation."
Q5
"An adjustable peg's discrete devaluation acts like a one-time monetary expansion."

0 / 5 answered

Exam pitfalls

Saying fiscal policy is 'most powerful' under flexible FX. It's the opposite — fixed FX neutralizes crowding-out from FX appreciation.
Forgetting that under fixed FX, M^s adjusts endogenously to defend the peg.
Confusing nominal and real exchange rates in MF questions.
Saying 'all three trinity goals can be hit'. They cannot — pick exactly two.