Mundell–Fleming Model (IS–LM–BP) & Policy Under Fixed vs Flexible Exchange Rates

1) What is the Mundell–Fleming model?

The Mundell–Fleming model is an open-economy extension of the IS–LM framework. It explains how output (Y) and interest rate (r) are determined when:

the economy trades with the rest of the world,
capital flows respond to interest rate differences,
exchange rate regime matters.

Many syllabi summarize it as IS–LM–BP:

IS: goods market equilibrium
LM: money market equilibrium
BP: balance of payments equilibrium

2) The three curves: meaning (CUET-level)

2.1 IS curve (goods market)

Shows combinations of (Y, r) where:

Y = C + I + G + (X - M)

In open economy, net exports depend on:

domestic income (imports rise when Y rises),
exchange rate (depreciation tends to raise net exports).

So open-economy IS is influenced by exchange rate movements.

2.2 LM curve (money market)

Shows combinations of (Y, r) where:

M^s = M^d(Y, r)

Similar to closed economy: higher Y raises money demand; higher r reduces speculative money demand.

2.3 BP curve (external balance)

Represents combinations of (Y, r) where balance of payments is in equilibrium:

CA + KA = 0

Intuition:

Higher Y → higher imports → CA worsens.
Higher r → attracts capital inflows (KA improves) if capital is mobile.

So BP is typically upward sloping in (Y, r) space:

to maintain external balance at higher Y (worse CA), you need higher r (better capital inflow).

Special case: perfect capital mobility If capital is perfectly mobile, BP becomes nearly horizontal at world interest rate $r^*$ .

3) Key assumption: capital mobility

Mundell–Fleming results depend on how easily capital moves across borders:

low mobility: BP steeper
high mobility: BP flatter
perfect mobility: BP horizontal at $r=r^*$