The Mundell-Fleming model extends IS-LM to an open economy by adding the balance of payments constraint (BP curve). The key insight is the impossible trinity (policy trilemma): a country cannot simultaneously have a fixed exchange rate, free capital mobility, and independent monetary policy — it must sacrifice one. Under floating exchange rates and free capital mobility, monetary policy is highly effective (exchange rate adjustment amplifies it), but fiscal policy is largely ineffective (appreciation offsets the stimulus by reducing net exports). Under fixed exchange rates, the reverse holds: fiscal policy is effective, monetary policy is not.
Work through the four scenarios: fiscal/monetary policy under fixed vs. floating exchange rates. For each, trace through IS-LM and the exchange rate response. Compare the eurozone (fixed exchange rates among members) with the UK or US (independent monetary policy).
From your IS-LM prerequisite, you know the closed-economy equilibrium: the IS curve represents combinations of output and interest rates where the goods market clears (investment equals saving), and the LM curve represents combinations where the money market clears. Their intersection gives equilibrium output and the domestic interest rate. The Mundell-Fleming model extends IS-LM to an open economy by adding a third equilibrium condition: the balance of payments must balance. The key new element is capital mobility — when investors can move funds internationally, a domestic interest rate above the world rate attracts capital inflows, which creates pressure on the exchange rate. The exchange rate regime then determines how the system adjusts.
The BP curve represents combinations of output and interest rates at which the current account deficit exactly equals the capital account surplus — the overall balance of payments is zero. Under perfect capital mobility, the BP curve is horizontal at the world interest rate i*. Any domestic interest rate above i* attracts unlimited capital inflows until rates equalize; any rate below triggers unlimited outflows. This constraint is what generates the impossible trinity: you cannot simultaneously maintain (1) a fixed exchange rate, (2) perfect capital mobility, and (3) an independent domestic interest rate (monetary policy). Attempt all three: raise domestic rates above i* to stimulate the economy; capital floods in; the central bank must buy incoming foreign currency to maintain the fixed exchange rate, expanding the money supply, which lowers domestic rates back to i* — the policy is self-defeating.
Under floating exchange rates with perfect capital mobility — the regime of the US, UK, and Japan today — the results are asymmetric. Monetary expansion lowers the domestic interest rate, triggering capital outflow, which depreciates the exchange rate, which makes exports cheaper and imports more expensive, boosting net exports and shifting IS rightward. The exchange rate amplifies the monetary stimulus. Fiscal expansion does the opposite: higher government spending shifts IS right, raising the interest rate, attracting capital inflows, appreciating the exchange rate, and reducing net exports. The fiscal stimulus is almost entirely crowded out via exchange rate appreciation rather than via higher interest rates. In the extreme case of perfect capital mobility, fiscal policy has zero effect on output under floating rates — a strong result that holds approximately for large open economies.
Under fixed exchange rates, the results reverse. Fiscal expansion works: higher spending raises output and the interest rate, attracting capital inflows, which the central bank offsets by buying foreign currency (selling domestic), expanding the money supply — the LM curve shifts right automatically, amplifying the fiscal stimulus. Monetary policy fails: if the central bank tries to expand the money supply, downward pressure on the exchange rate forces it to sell foreign reserves to defend the peg, contracting the money supply — the policy is automatically reversed. This is precisely why eurozone member countries during the 2010–2012 crisis could not use monetary policy to counter the recession and were forced to rely on fiscal policy, which itself was constrained by debt sustainability concerns — a double bind created by the fixed-rate regime.
The model's deepest contribution is reframing the exchange rate regime as a policy choice with direct consequences for which tools are available. Emerging markets face this tradeoff most acutely. A fixed exchange rate provides credibility, reduces uncertainty for trade partners, and imports monetary discipline from abroad — valuable when domestic institutions are weak or inflation history is poor. But it surrenders monetary independence and requires substantial foreign reserve buffers to defend against speculative attack. The 1997 Asian financial crisis and the 2001 Argentine collapse both featured countries that maintained pegged exchange rates with capital mobility until the reserves needed to defend the peg were exhausted. Understanding the trilemma is the lens through which to analyze these crises: in each case, the impossible trinity resolved itself violently when the peg broke, rather than gradually through policy adjustment.