Mundell-Fleming model

The Mundell–Fleming model, also known as the IS-LM-BoP model (or IS-LM-BP model), is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM Model. Whereas the traditional IS-LM Model deals with economy under autarky (or a closed economy), the Mundell–Fleming model describes a small open economy. Mundell's paper suggests that the model can be applied to Zurich, Brussels and so on.

The Mundell–Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closed-economy IS-LM model, which focuses only on the relationship between the interest rate and output). The Mundell–Fleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," "irreconcilable trinity," "inconsistent trinity" or the "Mundell–Fleming trilemma."

Basic assumptions of the model are as follows:

This model uses the following variables:

The Mundell–Fleming model is based on the following equations.

The IS curve:

where NX is net exports.

The LM curve:

A higher interest rate or a lower income (GDP) level leads to lower money demand.

The BoP (Balance of Payments) Curve:

where BoP is the balance of payments surplus, CA is the current account surplus, and KA is the capital account surplus.

where E(π) is the expected rate of inflation. Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending.

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