Mundell-Fleming Open-Economy IS-LM
IS-LM for an open economy. Demonstrates the impossible trinity: free capital flows, fixed FX, independent monetary policy — pick two.
Built and reviewed by Stephen Omukoko Okoth
Mathematical Economist · ex-Morgan Stanley FI · Equilar
Theory
What the model says, and why
Mundell-Fleming extends IS-LM to an open economy with capital mobility. A third equilibrium condition — balance of payments — pins down the relationship between the domestic interest rate r and the world rate r*. Under perfect capital mobility, r must equal r*; deviations trigger arbitrage capital flows that move either the exchange rate (floating regime) or the money supply (fixed regime).
The IS curve now includes net exports, which respond to the real exchange rate e (currency depreciation ↑e raises NX). Imports drag on demand via mᵧ. Otherwise the structure mirrors closed-economy IS.
The trilemma. A country can pick at most two of: free capital movement, a fixed exchange rate, and independent monetary policy. Mundell-Fleming makes the constraint mechanical: under floating rates, monetary policy works through e and is potent (fiscal is weak — full crowding out via FX). Under fixed rates, monetary policy is impotent (M endogenous to defend the peg), but fiscal policy is amplified.
Interactive playground
Move the parameters, watch the equilibrium move
Parameters
Open-economy IS-LM-BP
Money market
Equilibrium
Y* = 566, r* = 4.00%
Output Y*
566
Domestic r*
4.00%
World rate r*
4.00%
BP curve
Exchange rate e*
97.08
Adjusts to clear BP
In the classroom
How to teach it well
The trilemma in three buttons. Switch between floating and fixed FX, then change A or M/P and watch which adjustment variable carries the load. Floating: e moves; fiscal is partially crowded out. Fixed: M/P moves; fiscal is amplified, monetary policy can't deviate from r*.
Floating: monetary policy is potent. Raise M/P. LM shifts right. Domestic r tries to fall below r*. Capital flies out. The currency depreciates (e ↑), boosting NX, shifting IS right back to where r = r*. Output expands strongly. Fiscal expansion has the opposite story: capital flies in, currency appreciates, NX falls — full crowding out via FX.
Fixed: fiscal policy is potent. Raise A. IS shifts right. Domestic r rises above r*. Capital flies in. To defend the peg the central bank buys foreign currency, expanding M/P, shifting LM right until r = r*. Output expands maximally — no monetary crowding-out. Monetary expansion attempts are neutralised by FX intervention.
Real-world wrinkles. Imperfect capital mobility makes BP upward-sloping rather than horizontal. Sterilised intervention briefly delays the LM adjustment under fixed rates. Sudden stops (capital-flow reversals) flip the polarity entirely — depreciations become contractionary when balance sheets are dollarised.