Open an economy to trade and capital and two of macro’s most reliable levers stop behaving. A fiscal expansion that would lift output at home can fall flat once the exchange rate floats; a currency peg reverses which policies bite at all. That inversion is where second-years first meet the Mundell–Fleming model, and pinning down why brings intermediate students to an economics tutor in Australia.
1 · From the closed economy to the small open economy
In a closed economy the IS–LM model settles output and the interest rate together — that machinery is its own lesson, assumed here. Opening the borders changes two things.
First, capital moves. In a small open economy — too small to move the world interest rate — free capital flows force the domestic rate to the world rate by arbitrage: r = r*. Push above and it floods in; fall below and it flees. The parity conditions behind this are their own topic; here r = r* is given.
Second, spending leaks abroad. Net exports NX depend on the exchange rate e. Quote e as the foreign currency one unit of home currency buys, so a rise in e is an appreciation — home goods dearer abroad, foreign cheaper at home, net exports fall. Hold that convention fixed; flipping it midway causes most sign errors.
2 · The IS* and LM* curves in exchange-rate space
Plot the exchange rate e up the vertical axis and output Y along the horizontal.
The IS* curve is the goods market, Y = C(Y − T) + I(r*) + G + NX(e). Investment is fixed at r*, purchases G are policy, and net exports fall as e rises — so a higher e weakens NX and, through the multiplier, lowers output: IS* slopes downward in (Y, e).
The LM* curve is the money market, M/P = L(r, Y). But r is nailed to r*, so with M/P given, only one output clears it — and that output does not depend on e. LM* is vertical. The money market pins Y; the exchange rate then moves to clear goods, and the crossing is the equilibrium.
3 · Floating rates: monetary policy works, fiscal policy does not
Let the exchange rate float freely. The central bank sets M; the market sets e.
Fiscal expansion. Raise G and IS* shifts right — but the vertical LM* has not moved, so the crossing rises straight up and output does not budge. What moves is e: it appreciates, and the stronger currency cuts net exports by exactly the rise in G — full crowding out, not through a higher interest rate (which cannot leave r*) but through the exchange rate. Under a float, fiscal policy moves the currency, not output.
Monetary expansion does the opposite: raising M shifts LM* right, the crossing slides down IS*, and output rises as the currency depreciates and net exports climb. Under a float, monetary policy is potent — working through trade, since the rate cannot fall to spur investment.
4 · Fixed rates: the mirror image
Now the central bank pegs e, so it must buy and sell reserves to hold the rate — and every intervention changes the money supply. That flips both results.
Fiscal expansion. IS* shifts right and pushes e up; to stop the appreciation the bank sells home currency for reserves, expanding the money supply and dragging LM* right until output has risen enough to hold the peg. Fiscal policy now earns its full multiplier, no exchange-rate offset — the accommodation is automatic. Under a peg, fiscal policy is potent.
Monetary expansion is the casualty. Raise M and e starts to fall; defending the peg forces the bank to buy its currency back until M returns exactly to where it began. Under a peg, M is no longer a lever but whatever the peg requires — monetary policy is impotent.
5 · The trilemma, and one honest caveat
The pattern is one principle. A country cannot have all three of a fixed exchange rate, free capital movement, and independent monetary policy — only two. Float and you keep monetary control but lose exchange-rate stability; peg with open capital and you gain stability but lose monetary control; to keep both you must close the capital account. This impossible trinity is just the model’s three assumptions, read as a choice.
One caveat. It all rides on r = r*, perfect capital mobility. Real capital moves fast but not instantly, so the domestic rate can drift from r* and the sharp results soften — treat perfect mobility as the clean benchmark, not the territory.
Worked example — a fiscal expansion, floating then fixed
Take a small open economy with a spending multiplier of 2.5 (marginal propensity to consume 0.6) and a world rate r* = 5.
Step 1 — Goods market. Spending independent of e sums to 400 (consumption, investment at r*, G = 100, net exports), and net exports fall by 2 per unit of e. Through the multiplier, IS* is Y = 2.5 × (400 − 2e) = 1000 − 5e.
Step 2 — Money market. With M/P = 400 and money demand M/P = Y − 20r*, the fixed r* = 5 gives 400 = Y − 100, so Y is pinned at 500 — LM* is vertical there.
Step 3 — Base equilibrium. IS* then gives 500 = 1000 − 5e, so e₀ = 100.
Step 4 — The shock (floating). G rises by 50 to 150, shifting IS* right to Y = 1125 − 5e — a shift of 2.5 × 50 = 125.
Step 5 — Resolve (floating). LM* still pins Y = 500, so the new IS* gives e = 125: output unchanged, the currency appreciated. Net exports fall 2 × 25 = 50 — exactly the rise in G, fully crowded out through trade.
Step 6 — Pegged, and the verdict. Hold e = 100 instead: e cannot move, so output reads off the new IS* as Y = 1125 − 500 = 625, and the bank must expand M/P to 525 to pin it — the full 125. Same economy, same expansion, opposite outcomes: nothing floating, everything pegged. The policy did not change; the regime did. That contrast is the diagram below.
Same fiscal expansion, floating then pegged — could you say which regime moves output and which only moves the currency, and prove it? Reading the regime before touching a curve is exactly what Mundell–Fleming questions reward. A one-on-one economics tutor derives IS* and LM* with you until the four policy outcomes are results you rebuild, not a table you memorise. Book a trial session.
Practice
Q1. A small open economy has IS* Y = 1200 − 4e and a vertical LM* pinning Y = 600. (a) Find the equilibrium exchange rate. (b) Under a floating rate, purchases rise and shift IS* to Y = 1400 − 4e — find the new output and exchange rate. (c) Now hold the rate fixed at its original level; find the new output and compare with (b).
Answers. (a) 1200 − 4e = 600 gives e = 150. (b) LM* still pins Y = 600, so 1400 − 4e = 600 gives e = 200: output unchanged at 600, the currency appreciating 150 → 200 — full crowding out under a float. (c) with e fixed at 150, Y = 1400 − 4 × 150 = 800 — a rise of 200, the full multiplier effect, against zero in (b). Same shock, opposite result, decided by the regime.
Key takeaways
- Two curves in (Y, e) space: a downward-sloping IS* (appreciation cuts net exports) and a vertical LM* — r = r* leaves output the only thing free to clear the money market.
- LM* fixes output; IS* fixes the exchange rate that clears goods at that output.
- Floating: monetary policy works, fiscal does not. Fiscal expansion only appreciates the currency, crowding out net exports one-for-one; monetary expansion depreciates it and raises output.
- Pegged: the results invert. Defending the peg makes the money supply endogenous, so fiscal earns its full multiplier and monetary policy has no lasting effect. This is the trilemma — fixed rate, free capital, monetary independence: pick two.
Why Australian students choose our economics tutoring
- The regime is where marks are won: you learn to spot whether a question is floating or fixed before touching a curve, so the sign of every result falls out cleanly, not from memory.
- Model built, not quoted: you derive IS* and LM* from the goods and money markets, so you can rebuild and adapt them under exam pressure.
- The distinctions examiners reward, drilled: float versus peg, crowding out through the rate versus through interest, perfect versus imperfect capital mobility.
- In person across Sydney, Melbourne and Perth, or online: one-on-one sessions work from your own notation and past papers, whether your macro course follows Mankiw, Blanchard, or Burda and Wyplosz.
FAQ
Q: Why is the LM* curve vertical in Mundell–Fleming?
A: Perfect capital mobility fixes the domestic rate at r*, so the money market clears at one output — independent of the exchange rate.
Q: Why doesn’t fiscal policy raise output under a floating rate?
A: The vertical LM* holds output fixed, so the fiscal push only appreciates the currency, cutting net exports by the amount spending rose.
Q: How is crowding out here different from closed-economy IS–LM?
A: In a closed economy the interest rate rises and crowds out investment; here the rate is stuck at r*, so the appreciation crowds out net exports.
Q: Why does monetary policy stop working under a fixed rate?
A: Defending the peg forces the bank to reverse any change in the money supply, so M ends up where it started — no lasting effect.
Q: What is the impossible trinity?
A: You cannot have a fixed exchange rate, free capital movement, and independent monetary policy at once — only two of the three.
Book an economics tutor in Australia or online
Mundell–Fleming rewards the student who can read the regime and derive the result, not recite four outcomes and hope to match them. One-on-one sessions build that fluency on your own past papers — the vertical LM*, the exchange-rate channel, the limits of perfect mobility. Tell us your module and exam date, and we will match you with the right tutor this week.
