Interactive modelAdvanced Macro & Growthadvanced

Mundell-Fleming

IS-LM with exchange rates: why policy works completely differently under fixed vs. floating regimes.

Equilibrium: Y* = 53.3, r* = 4.7

Current equations

IS: r = 9 − 0.08·YLM: r = 1 + 0.07·YBP (r*): r = 4.73

IS-LM goes global: the dashed BP line marks the world interest rate. Whenever domestic policy pushes r off that line, capital floods in or out, and the exchange rate takes over the story.

Source: Blanchard, Macroeconomics, ch. 19-20

Shift the curves

Fiscal policy (G up / T down)0

Fiscal expansion pushes r above r*: capital flows in and the currency appreciates.

Monetary policy (money supply)0

Easing pushes r below r*: capital flows out and the currency depreciates.

The Mundell-Fleming model, in writing

Definition

IS-LM opened to the world: with capital mobile across borders, the exchange-rate regime decides which policy works. Floating rates make monetary policy powerful and fiscal policy weak; fixed rates do the reverse.

IS*: Y = C + I + G + NX(e) ; LM*: M/P = L(r*, Y) with r pinned to the world rate

The intuition

Under floating rates, fiscal expansion pulls in foreign capital, appreciates the currency, and the lost net exports undo the stimulus; monetary expansion depreciates the currency and works doubly. Under fixed rates, the central bank must defend the peg, so it loses monetary independence entirely: the policy trilemma in action.

Exam tip

First state the regime and capital mobility, then trace the exchange-rate step explicitly. 'Fiscal ineffective under floating, monetary ineffective under fixed' is the result to prove, not just assert.

Related models in Advanced Macro & Growth

IS-LM →Fisher Equation →Government Budget Constraint & Seigniorage →Solow-Swan Growth Model →