The Mundell-Fleming model is the open-economy version of the IS-LM system, with a third relation for the external balance. Its whole content is that monetary and fiscal policy swap effectiveness depending on the exchange-rate regime, and that the swap runs in opposite directions for the two policies.
Worked example: a small open economy
Rather than reason it out in words, solve it. Take a small open economy with these behavioural equations, where the interest rate is measured in percentage points and q is the percentage real depreciation of the home currency from its base level:
C = 100 + 0.75 (Y − T), T = 400
I = 300 − 20 i
NX = 110 − 0.10 Y + 15 q
LM: M/P = 0.5 Y − 25 i, M/P = 800
BP: i = i* = 4 (perfect capital mobility)
G = 500At base, the money market alone fixes output. Solving 800 = 0.5Y − 100 gives Y = 1,800, with consumption of 1,150, investment of 220, and the goods-market identity fixing the exchange rate at q = 0 with net exports of −70. Every cell starts there, and Worked Example 4 solves all four.
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How do monetary and fiscal policy work in each regime?
The mechanism is the same in every cell and only the binding constraint changes. Under a float with mobile capital, the interest rate is pinned at the world rate and the money market alone determines output, so fiscal policy cannot move output at all: the goods market clears through the exchange rate instead, which appreciates 4.00% and cuts net exports by exactly the 60 of extra spending. Monetary policy in the same cell is powerful, raising output 100 on a 50 injection and depreciating the currency 2.3333%.
Fix the exchange rate and the constraint swaps places. The money supply is now whatever defending the parity requires, so it can no longer pin output, and a fiscal expansion of 60 raises output by 171.428571, the open-economy multiplier of 2.857143 applied to the spending, while reserves rise 85.714286 in the act of stopping the currency appreciating. The defence of the peg is what finances the expansion. Monetary policy in that cell is not weak but unavailable: the injection pushes the domestic rate below the world rate, capital leaves, and the bank has to sell 50 of reserves buying back its own currency, restoring the money supply and leaving output at 1,800.
Assemble the four cells with the exchange-rate prediction in each, and add the low-mobility rows, where the external balance is dominated by trade flows rather than capital flows:
| Capital mobility | Regime | Policy | Output effect | Exchange rate / reserves |
|---|---|---|---|---|
| High | Floating | Monetary expansion | strong, +100 | depreciates, q = +2.3333% |
| High | Floating | Fiscal expansion | none, 0 | appreciates, q = −4.00% |
| High | Fixed | Monetary expansion | none, 0 | reserves fall 50 |
| High | Fixed | Fiscal expansion | strong, +171.43 | reserves rise 85.71 |
| Low | Floating | Monetary expansion | positive | depreciates (both channels agree) |
| Low | Floating | Fiscal expansion | positive | depreciates, because import leakage outruns the capital inflow |
| Low | Fixed | Monetary expansion | none | reserves fall |
| Low | Fixed | Fiscal expansion | positive | reserves fall as imports rise |
The low-mobility case and the limits of the model
The low-mobility fiscal cell is the one worth memorising, because it reverses the high-mobility answer. When capital cannot move freely, a fiscal expansion raises output, output raises imports, and the trade deficit widens faster than the higher interest rate can attract offsetting capital. In the system above, a 60-unit fiscal expansion with the interest rate pinned raises output by 171.428571, which pulls in 17.142857 of extra imports, and it would take a real depreciation of 1.142857% just to offset the leakage. Under a float that depreciation happens. The textbook prediction that fiscal expansion strengthens a currency is a high-mobility prediction, and applying it to an economy with capital controls gets the sign backwards.
Three honest limits before you use any of this. The model has fixed prices, so it says nothing about inflation. It has static expectations, so nothing in it anticipates. And "perfect capital mobility" is an idealisation that no economy with a functioning capital-controls regime satisfies. The value of the model is the sign table, not the magnitudes.