1
Reference: Froyen (Chapter 15)
EXEE1104/ EIA1003
Macroeconomics I
Lecture 10
Monetary and Fiscal Policies
in the Open Economy

2
THE MUNDELL-FLEMING MODEL
The closed economy IS –LM:
Money market equilibrium:
M = L (Y, r)
(1)
Goods market equilibrium:
S (Y) + T = I(r) + G
(2)
When IS = LM, the nominal interest rate (
r
) and the level of real income (
Y
),
with aggregate price constant, is determined.

3
In an open economy, the LM will not change:
Equation (1) states that real money supply controlled by the domestic
policymaker, must in equilibrium equal to the real demand for money
From equation (2), the IS for the goods market equilibrium in a closed
economy:
C + S + T = C + I + G
(3)
When C is subtracted from both sides,
S + T = I + G
(4)
The IS relation for an open economy – include imports (Z) and exports (X):
S + T = I + G + X – Z
(5)
Contd.

4
The open economy IS relation can be rewritten as:
S(Y)+ T + Z(Y, π) = I(r) + G + X(Y
f
, π)
(6)
S
and
I
are the same as in closed economy
Imports depend positively on income (
Y
) and negatively on exchange rate
(
π
).
Exchange rate – price of foreign currency.
A rise in exchange rate means foreign goods are relatively more
expensive.
Contd.

5
The IS in Figure 10.1 is downward sloping.
High r will result in low I.
To satisfy equation (6), at such high level of r, Y must be low so that levels
of Z and S will be low (high
i
– income low – Z and S low).
In constructing the IS, four variable are held constant:
G
,
T
,
Y
f
(foreign
income) and
π.
These are the variables that shift the IS curve.
Contd.

6
Figure 10.1 – Open Economy IS –LM Model
In addition to IS and LM, open economy
consists of balance of payment schedule,
BP.
BP: all interest rate – income
combinations that result in BOP
equilibrium at a given exchange rate.
BP equilibrium means that official reserve
transaction balance is zero.
The BP:
X(Y
f
, π) – Z(Y, π) + F(r – r
f
) = 0
(8)
r
Y
IS
BP
LM

7
The BP schedule is given as:
X(Y
f
, π) – Z(Y, π) + F(r – r
f
) = 0
(8)
The first two terms is the trade balance (net exports)
The third item (
F
) is the net capital inflow (the surplus or deficit in the
capital account)
The net capital inflow depends positively on the interest rate minus foreign
interest rate
(r – r
f
).
A rise in the domestic interest rate leads to increased demand for
domestic assets (net capital inflow increases);
A rise in the foreign interest rate leads to increased demand for foreign
assets (net capital outflow increases).
Contd.

8
The BP schedule is positively sloped.
As Y rises, Z increases, X does not. To maintain the BP equilibrium, capital
inflow must increase (which will happen if r is higher).
Factors that shift BP: Increase in
π
will shift BP to the right.