The open economy: Mundell–Fleming

A closed economy neither exports nor imports (CUET 2021). Open it, and spending on home goods adds exports X and subtracts imports M, which rise with income at the marginal propensity to import m. Imports are a leakage like saving and taxes, so the multiplier gets smaller: the open economy’s IS curve is steeper than the closed one’s (JNU 2011), and a higher propensity to import weakens fiscal policy (JNU 2018).

Rearranging the national income identity gives the key open-economy relation: what a country saves beyond its own investment it lends abroad, and that is its current-account surplus.

With perfect capital mobility, a small country’s interest rate cannot differ from the world rate r*. If it rose even slightly, capital would pour in; if it fell, capital would leave. So the balance of payments is in equilibrium only at r = r*, and the BP curve is horizontal there (JNU 2018).

The balance of payments is the current account plus the capital account. If the central bank’s reserves don’t change, the two must add to zero: the overall balance is zero (CUET 2026). Under a fixed rate, a BoP surplus or deficit is exactly what the central bank buys or sells in reserves to hold the rate.

We write e for the value of the home currency: a rise is an appreciation, which makes exports dearer and imports cheaper, so net exports fall. (Whether a depreciation improves the trade balance needs export and import elasticities to add to more than one, the Marshall–Lerner condition.)

Robert Mundell and Marcus Fleming, in the early 1960s, put IS–LM into a small open economy with perfect capital mobility and a fixed price level. Mankiw’s version draws it in income and the exchange rate:

Its lesson is that the power of monetary and fiscal policy depends on the exchange-rate regime (CUET 2019). With a floating rate, the money supply is fixed and the exchange rate adjusts; with a fixed rate, the exchange rate is fixed and the money supply adjusts, because the central bank must stand ready to buy or sell its currency at the fixed price.

Pick a regime and a shock. The readings show what happens to output, the exchange rate, net exports and the money supply.

Under floating rates the exchange rate does the work, not income: JAM 2023’s false statement was that the exchange rate matters for equilibrium income under a floating rate with perfect mobility, since income is pinned by LM*. GATE 2023 asked which policies work: fiscal expansion under a fixed rate and monetary expansion under a floating one. Under a floating rate, the central bank doesn’t intervene in the currency market when it expands the money supply (DSE 2019).

The fixed-rate column shows a general rule. A country cannot have all three of free capital movement, an independent monetary policy and a fixed exchange rate: it must give up one. GATE 2026 asked which combination is not possible: exactly those three together. Hyderabad 2010’s option “independent monetary policy, free capital mobility and a floating rate” describes a possible combination, not the trilemma, so the answer was “none of the above”.

• Floating rate, free capital: monetary policy is autonomous (Hyderabad 2018). Most large economies.
• Fixed rate, free capital: monetary policy is given up. A currency union is the extreme case: a member’s own monetary policy is ineffective (JNU 2017).
• Fixed rate, independent policy: capital controls, as in Bretton Woods, or India before the 1990s.

When capital flows in and the central bank buys foreign currency to stop the rupee rising, its net foreign assets rise and it pays out rupees: the monetary base grows. To stop that raising the money supply, it can sell government bonds, cutting its domestic assets by the same amount. That is sterilisation: nullifying the effect of foreign-exchange operations on the domestic money supply (CUET 2023). A fully sterilised inflow leaves the base unchanged, with a rise in net foreign assets and a fall in domestic assets (CUET 2023). An open-market operation under a fixed rate with perfect mobility changes only the composition of the monetary base, not its size (DSE 2007).

If capital responds to interest differences but not infinitely, the BP curve slopes up in (Y, r): higher income raises imports and worsens the current account, so a higher interest rate is needed to attract enough capital. The flatter BP, the more mobile capital. Under a fixed rate:

• A monetary expansion lowers the interest rate and raises income, so both the capital account and the trade balance worsen: a BoP deficit whatever the slopes (JNU 2018; JAM 2024).
• A fiscal contraction lowers income (the trade balance improves) and the interest rate (capital flows out). If LM is steeper than BP, the fall in the rate dominates and the BoP goes into deficit (JAM 2024).

Fixed and floating rates, each with perfect, high, low and zero capital mobility, give sixteen cases in all. The IS–LM–BP guide works through every one with diagrams and a step-by-step lab.