Model Basics
This model extends IS-LM to describe a small open economy.
Mundell-Fleming model (IS-LM-BP)
The IS curve equation in an open economy.
Y = C + I + G + Xn
The two main exchange rate systems discussed in the Mundell-Fleming framework.
Fixed (pegged) & floating exchange rates
Under floating exchange rates, this policy is highly effective via the exchange rate channel.
Monetary policy
The three objectives a country cannot simultaneously achieve — the "impossible trinity."
Fixed exchange rate, free capital mobility, monetary autonomy
These two economists independently compiled the IS-LM-BP model.
Robert Mundell & Marcus Fleming
The LM curve equation in the Mundell-Fleming model.
M/P = L(r, Y)
Under a floating rate, fiscal expansion shifts the IS right but ultimately leaves income unchanged because this rises.
Exchange rate (currency appreciates)
Under fixed exchange rates, this policy is highly effective due to monetary accommodation.
Fiscal policy
The Eurozone sacrificed this corner of the trilemma by adopting a common currency.
Monetary autonomy
The basic condition that anchors the Mundell-Fleming model.
r = r* (domestic rate equals world rate)
The BP curve is the sum of these two accounts.
Current account (CA) + Capital account (KA)
Under a fixed rate, fiscal expansion shifts both IS and this curve to the right, raising income.
LM curve (via monetary accommodation)
Under floating rates, fiscal expansion is fully offset by a decline in this component of aggregate demand.
Net exports (NX) — complete crowding out
China retains a managed exchange rate and independent monetary policy by using these.
Capital controls
The three endogenous variables in the Mundell-Fleming model.
Y (income), r (interest rate), e (exchange rate)
In the Y-∈ diagram, this curve is vertical because exchange rate does not enter its equation.
LM curve
Under a floating rate, monetary expansion causes this to fall, boosting net exports.
Exchange rate (currency depreciates)
Under fixed rates, monetary policy is completely ineffective because any expansion triggers this.
Capital outflows → reserve depletion → LM shifts back
The three distinct aspects of economic openness described in the model.
Goods & services market, financial market, resource market
The assumption that classifies an economy as "small open" — it cannot influence this.
Global interest rate or world prices
Under perfect capital mobility, the BP curve takes this shape at r = r*.
Horizontal (flat)
Under a fixed rate, any monetary expansion is automatically reversed by this central bank action.
Selling foreign reserves to defend the peg
This Mundell principle assigns each policy instrument to the target over which it has the strongest relative effect.
Principle of effective market classification
This economist argued the trilemma is effectively a dilemma — capital mobility and monetary autonomy are the real trade-off.
Hélène Rey