How does the Mundell-Fleming model predict the effect of monetary and fiscal policy on exchange rates?

The Mundell-Fleming model extends IS-LM to an open economy with international capital flows. The key insight is that the exchange rate regime and capital mobility determine which policy is effective.

The Core Framework:

Three components:

1. IS curve — Goods market equilibrium (affected by fiscal policy and net exports)
2. LM curve — Money market equilibrium (affected by monetary policy)
3. BP curve — Balance of payments equilibrium (affected by capital flows and trade)

The Impossible Trinity:

A country can only have 2 of these 3 simultaneously:

• Free capital mobility
• Independent monetary policy
• Fixed exchange rate

Key Scenarios (High Capital Mobility):

Scenario 1: Expansionary Monetary Policy + Floating Rate

1. Central bank increases money supply → interest rates fall
2. Capital outflows (investors seek higher returns abroad)
3. Domestic currency depreciates
4. Net exports increase (cheaper currency boosts competitiveness)
5. IS curve shifts right → output increases
6. Monetary policy is effective because the exchange rate channel amplifies the stimulus

Scenario 2: Expansionary Fiscal Policy + Floating Rate

1. Government increases spending → IS shifts right → interest rates rise
2. Capital inflows (attracted by higher rates)
3. Domestic currency appreciates
4. Net exports decrease (stronger currency hurts competitiveness)
5. This crowds out the fiscal stimulus through the exchange rate
6. Fiscal policy is ineffective (or less effective)

Scenario 3: Expansionary Monetary Policy + Fixed Rate

1. Central bank increases money supply → interest rates fall
2. Capital outflows → pressure for currency to depreciate
3. Central bank must buy domestic currency (sell reserves) to maintain the peg
4. This contracts the money supply back to its original level
5. Monetary policy is completely ineffective under fixed rates with high capital mobility

Scenario 4: Expansionary Fiscal Policy + Fixed Rate

1. Government increases spending → interest rates rise
2. Capital inflows → pressure for currency to appreciate
3. Central bank must sell domestic currency (buy reserves) to maintain the peg
4. This expands the money supply, reinforcing the fiscal stimulus
5. Fiscal policy is highly effective under fixed rates

Exam tip: The CFA Level II exam loves presenting a scenario and asking what happens to the exchange rate, interest rates, and output. Memorize the 4 key scenarios for high capital mobility and practice tracing through the transmission mechanism step by step.

For more international economics content, explore our CFA Level II course on AcadiFi.