Questions: Mundell-Fleming Model and Open Economy Macroeconomics

Question 1

Under a floating exchange rate with perfect capital mobility, a government increases spending significantly on infrastructure. What does the Mundell-Fleming model predict will happen to national output?

• A. Output rises substantially — the fiscal multiplier works as in the standard closed-economy IS-LM model
• B. Output rises slightly — some interest rate crowding out partially offsets the stimulus, as in the closed economy
• C. Output is largely unchanged — the currency appreciates, reducing net exports by approximately as much as government spending increased
• D. Output falls — the currency appreciation more than offsets the spending increase, creating a net contractionary effect

Answer: (C)

Under floating rates, fiscal expansion shifts IS rightward, initially raising income and interest rates. The higher rates attract capital inflows, appreciating the currency. The stronger currency makes exports more expensive and imports cheaper, reducing net exports — shifting IS back leftward. With perfect capital mobility, this process is essentially complete: the IS curve returns near its original position at the world interest rate, leaving output largely unchanged. The crowding-out mechanism operates through the exchange rate rather than interest rates, unlike the closed-economy case.

Question 2

A country with a fixed exchange rate and perfect capital mobility tries to stimulate the economy via open market bond purchases, expanding the money supply. What ultimately happens?

• A. The money supply expansion is sustained and output rises as domestic interest rates fall below world rates
• B. Capital inflows allow the central bank to permanently expand the money supply while holding the exchange rate fixed
• C. Capital outflows (as domestic rates fall below world rates) force the central bank to sell foreign reserves and contract the money supply, fully reversing the original expansion
• D. Inflation quickly erodes the real money supply back to its original level, neutralizing the stimulus

Answer: (C)

With a fixed exchange rate and perfect capital mobility, any attempt to expand the money supply causes domestic interest rates to briefly fall below world rates. Capital immediately flows out seeking higher returns abroad. To defend the fixed exchange rate and prevent depreciation, the central bank must sell foreign reserves and buy domestic currency — contracting the money supply back to its original level. Monetary policy is completely impotent: any expansion is automatically undone by the balance of payments adjustment required to maintain the peg.

Question 3

Under the Mundell-Fleming model with fixed exchange rates and perfect capital mobility, fiscal expansion is more powerful than in a closed economy because the central bank must expand the money supply to defend the exchange rate peg.

• T. True
• F. False

Answer: True

Fiscal expansion raises domestic interest rates, attracting capital inflows. To prevent currency appreciation, the central bank must buy foreign reserves (selling domestic currency) — which expands the money supply. This automatic monetary accommodation reinforces the fiscal expansion: both IS and LM shift rightward simultaneously, amplifying the fiscal multiplier beyond the closed-economy case. Fixed exchange rate regimes effectively make monetary policy subordinate to the exchange rate target, leaving fiscal policy as the dominant stabilization tool.

Question 4

Under the Mundell-Fleming model, a country with free capital mobility can independently set its exchange rate target and domestic interest rate simultaneously while also conducting independent monetary policy.

• T. True
• F. False

Answer: False

This violates the Mundell-Fleming trilemma (impossible trinity): a country cannot simultaneously maintain free capital mobility, a fixed exchange rate, and an independent monetary policy. Free capital mobility arbitrages away interest rate differentials — forcing domestic rates toward the world rate. A fixed exchange rate requires the central bank to intervene in currency markets, which endogenously determines the money supply. Only two of the three can hold at once. This constraint is one of the most robust organizing principles in international macroeconomics.

Question 5

Explain why fiscal policy is ineffective under floating exchange rates but effective under fixed exchange rates in the Mundell-Fleming model. What mechanism creates this reversal?

Model answer: Under floating rates, fiscal expansion raises domestic interest rates, attracting capital inflows that appreciate the currency. The stronger currency reduces net exports — a form of crowding out operating through the exchange rate. With perfect capital mobility, this crowding out is complete, leaving output unchanged. Under fixed rates, the same fiscal expansion attracts capital inflows, but the central bank must intervene to prevent appreciation by buying foreign reserves and expanding the money supply. This automatic monetary accommodation amplifies the fiscal multiplier rather than neutralizing it. The reversal occurs because the exchange rate regime determines whether capital-flow-driven pressure is absorbed by currency adjustment (floating, where it crowds out net exports) or by money supply expansion (fixed, where it reinforces the stimulus).

This symmetry is the core of Mundell-Fleming: whatever policy is powerful under one exchange rate regime is weak under the other. The institutional choice of exchange rate regime fundamentally reshapes the transmission mechanism of macroeconomic policy.