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IS-LM Model and Mundell-Fleming Model of Balance of Payments
1️⃣ Introduction
The IS-LM model and the Mundell-Fleming model are two fundamental macroeconomic models that help analyze economic equilibrium, monetary-fiscal policies, and balance of payments in closed and open economies.
- The IS-LM model is used for a closed economy and shows the interaction between the goods market (IS curve) and the money market (LM curve).
- The Mundell-Fleming model extends the IS-LM model to an open economy, incorporating exchange rates and capital mobility.
This blog will explore these models, their assumptions, equations, and policy implications.
2️⃣ IS-LM Model: The Keynesian Approach for a Closed Economy
📌 What is the IS-LM Model?
The IS-LM model (Investment-Savings & Liquidity Preference-Money Supply), developed by John Hicks based on Keynesian macroeconomics, explains how equilibrium is achieved in the goods and money markets.
✅ The IS curve represents equilibrium in the goods market (investment = savings).
✅ The LM curve represents equilibrium in the money market (money demand = money supply).
✅ The intersection of the IS and LM curves determines equilibrium output (Y) and interest rate (r).
📌 Derivation of IS and LM Curves
1. IS Curve (Goods Market Equilibrium)
The IS curve is derived from the equilibrium condition in the goods market: Y=C+I+GY = C + I + G
Where:
- YY = National income (GDP)
- CC = Consumption
- II = Investment
- GG = Government spending
Investment depends negatively on the interest rate (r), meaning higher interest rates reduce investment and lower output.
✔ Slope of the IS Curve: Downward-sloping → Higher interest rates reduce investment, lowering output.
2. LM Curve (Money Market Equilibrium)
The LM curve represents equilibrium in the money market: M/P=L(Y,r)M/P = L(Y, r)
Where:
- M/PM/P = Real money supply
- L(Y,r)L(Y, r) = Demand for money (depends on income and interest rate)
✔ Slope of the LM Curve: Upward-sloping → Higher income increases demand for money, raising interest rates.
📌 Policy Implications of IS-LM Model
1. Fiscal Policy (Government Spending & Taxes)
- Expansionary Fiscal Policy (↑G or ↓Taxes) → Rightward shift of IS curve → Higher output & higher interest rate.
- Contractionary Fiscal Policy (↓G or ↑Taxes) → Leftward shift of IS curve → Lower output & lower interest rate.
✔ Effectiveness: Works well unless the economy is in the liquidity trap (flat LM curve).
2. Monetary Policy (Changes in Money Supply)
- Expansionary Monetary Policy (↑M) → Rightward shift of LM curve → Lower interest rates & higher output.
- Contractionary Monetary Policy (↓M) → Leftward shift of LM curve → Higher interest rates & lower output.
✔ Effectiveness: Works well unless investment is insensitive to interest rates.
3️⃣ Mundell-Fleming Model: The IS-LM Framework for an Open Economy
📌 What is the Mundell-Fleming Model?
The Mundell-Fleming Model, developed by Robert Mundell and J. Marcus Fleming, extends the IS-LM framework to an open economy with foreign exchange markets and capital flows.
✅ The model examines how fiscal and monetary policies work under different exchange rate regimes (fixed vs. flexible).
✅ It introduces the Balance of Payments (BP) curve, which shows external equilibrium.
📌 Key Assumptions of the Mundell-Fleming Model
✔ Small open economy: The country takes world interest rates as given (r=r∗r = r^*).
✔ Capital mobility: Financial capital moves freely across borders.
✔ Exchange rate system: The effects depend on whether the exchange rate is fixed or floating.
📌 The Three Equations of the Mundell-Fleming Model
1. IS Curve (Goods Market Equilibrium in Open Economy)
Y=C+I+G+NXY = C + I + G + NX
Where:
- NXNX = Net Exports (X−MX – M), which depend on exchange rates.
✔ Depreciation of the domestic currency → ↑ Exports, ↓ Imports → Higher GDP.
✔ Appreciation of the domestic currency → ↓ Exports, ↑ Imports → Lower GDP.
2. LM Curve (Money Market Equilibrium)
M/P=L(Y,r)M/P = L(Y, r)
✔ Similar to the closed economy case but influenced by capital flows.
3. BP Curve (Balance of Payments Equilibrium)
BP=CA+KA=0BP = CA + KA = 0
Where:
- CACA = Current account (exports & imports).
- KAKA = Capital account (foreign investments).
✔ The BP curve is upward sloping if capital mobility is imperfect.
✔ If capital is perfectly mobile, BP is horizontal at r=r∗r = r^*.
4️⃣ Policy Implications of the Mundell-Fleming Model
📌 Under Fixed Exchange Rates
- Monetary Policy is Ineffective
- An increase in MM lowers interest rates, causing capital outflows.
- To maintain the fixed rate, the central bank sells foreign reserves to offset the outflows.
- No change in output YY.
✔ Example: China’s currency peg limits the effectiveness of monetary policy.
- Fiscal Policy is Highly Effective
- Higher government spending (G↑) shifts IS right, increasing output.
- Interest rates rise, attracting foreign capital, causing currency appreciation.
- To maintain the peg, the central bank buys foreign reserves, expanding the money supply.
- This further boosts output (Y).
✔ Example: The US during the Bretton Woods system (1944-1971).
📌 Under Flexible Exchange Rates
- Monetary Policy is Highly Effective
- Increasing money supply (M↑) shifts LM right, lowering interest rates.
- Capital outflows cause currency depreciation, making exports cheaper.
- Higher exports (NX↑) boost output.
✔ Example: US Federal Reserve’s monetary stimulus during COVID-19.
- Fiscal Policy is Ineffective
- Government spending (G↑) shifts IS right, raising interest rates.
- Capital inflows cause currency appreciation, reducing exports (NX↓).
- The decline in exports offsets the fiscal stimulus, so no change in output.
✔ Example: Japan’s failed fiscal expansion in the 1990s due to yen appreciation.
5️⃣ Conclusion
✔ The IS-LM model explains macroeconomic equilibrium for a closed economy, while the Mundell-Fleming model extends it to an open economy.
✔ Under fixed exchange rates: Fiscal policy is effective, but monetary policy is ineffective.
✔ Under flexible exchange rates: Monetary policy is effective, but fiscal policy is ineffective.
✔ Policymakers must consider exchange rate regimes when designing economic policies.
Final Thought: Given the rise in global trade and capital flows, do fixed or flexible exchange rates work better in today’s economy?