The Open Economy Revisited: The Mundell-Fleming Model

Y 5 C (Y 2 T) 1 I (r) 1 G 1 NX (e).

Let’s call this the ISequation. (The asterisk reminds us that the equation holds

the interest rate constant at the world interest rate r.) We can illustrate this equation

on a graph in which income is on the horizontal axis and the exchange rate

is on the vertical axis. This curve is shown in panel (c) of Figure 13-1.

The IScurve slopes downward because a higher exchange rate reduces net

exports, which in turn lowers aggregate income. To show how this works, the

other panels of Figure 13-1 combine the net-exports schedule and the Keynesian

cross to derive the IScurve. In panel (a), an increase in the exchange rate from

e1 to e2 lowers net exports from NX (e1) to NX (e2). In panel ( b), the reduction in

net exports shifts the planned-expenditure schedule downward and thus lowers

income from Y1 to Y2. The IScurve summarizes this relationship between the

exchange rate e and income Y.

The Money Market and the LM* Curve

The Mundell–Fleming model represents the money market with an equation

that should be familiar from the IS–LM model:

M/P 5 L (r, Y ).

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