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Lesson M20.L02: Mundell-Fleming Under Fixed Exchange Rates

Module: Open Economy Macroeconomics Part I Level: intermediate Duration: 30 minutes Learning Objective: Explain why monetary policy is ineffective under fixed exchange rates in the Mundell-Fleming model. Data as of: 2024 Provenance: MIT OCW 14.02 | IMF International Financial Statistics

Explanation

Under a fixed exchange rate regime, the central bank commits to maintain the nominal exchange rate e at a target value ē by standing ready to buy or sell foreign currency reserves. This commitment fundamentally changes how monetary and fiscal policy work.

The mechanism of fixing. If market pressure pushes e below ē (currency depreciation pressure), the central bank buys domestic currency (sells foreign reserves) — contracting the domestic money supply. If pressure pushes e above ē (appreciation pressure), it sells domestic currency (buys reserves) — expanding the money supply. The central bank loses control of M in order to control e.

Monetary policy under fixed exchange rates — fully ineffective.

  1. Suppose the central bank tries to expand the money supply (M↑) to stimulate the economy.
  2. M↑ → LM* shifts right → Y tends to rise and i falls below i*.
  3. With i < i*, capital flows out (investors seek higher foreign returns) → demand for foreign currency rises → e faces depreciation pressure.
  4. To defend the fixed rate ē, the central bank buys domestic currency (selling foreign reserves) → M contracts back to its original level.
  5. The LM* curve shifts back to its original position. Net effect on Y: zero.

The monetary expansion is entirely offset by the exchange rate defence. The money supply is endogenous — determined by the balance of payments, not the central bank's open market operations.

Fiscal policy under fixed exchange rates — fully effective.

  1. Suppose the government increases spending (G↑) → IS* shifts right.
  2. Y tends to rise → i rises above i*.
  3. With i > i*, capital flows in (attracted by higher domestic returns) → demand for domestic currency rises → e faces appreciation pressure.
  4. To defend ē, the central bank sells domestic currency (buying foreign reserves) → M expands.
  5. The LM* curve shifts right, amplifying the fiscal expansion.
  6. Net effect on Y: the full (Keynesian) multiplier, because the money supply passively accommodates.

Summary under fixed exchange rates: - Monetary policy: powerless (crowded out by exchange rate defence) - Fiscal policy: fully effective under perfect capital mobility (money supply accommodates via reserve flows; fiscal multiplier = full Keynesian cross multiplier)

Historical example. The Bretton Woods system (1944–1971) was a fixed exchange rate regime. Member countries could not independently conduct monetary policy — all had to maintain dollar pegs. Post-Bretton-Woods, Australia maintained a crawling peg until floating the AUD in December 1983, after which monetary policy became effective.

Notation: - e = nominal exchange rate; ē = fixed/target rate - M = nominal money supply; M/P = real money supply - i = domestic interest rate; i* = world interest rate - IS* shifts with G (fiscal); LM* shifts with M (monetary)

Worked Example

Question: An economy operates under fixed exchange rates with the following initial equilibrium. IS*: Y = 3,000 − 400ε. LM* pins Y = 3,000 (money market, with i = i* = 5%). The fixed exchange rate is ē = 1.0 (consistent with IS*-LM* equilibrium initially).

The government increases spending by ΔG = 100. With MPC = 0.75, how much does Y rise? Show the full mechanism.

Step 1 — Fiscal multiplier effect on IS* intercept.

\[\text{IS* shift} = \frac{\Delta G}{1 - MPC} = \frac{100}{1 - 0.75} = \frac{100}{0.25} = 400\]

New IS*: Y = (3,000 + 400) − 400ε = 3,400 − 400ε

Step 2 — Under floating rates (for comparison).

Under floating, the exchange rate adjusts to keep Y at the LM* level — ε rises and NX falls, exactly offsetting the rise in G. Output is unchanged. This is covered in M20.L03.

Step 3 — Under fixed rates with the recalibrated example.

Using NX = 200 − 100ε, initial IS*: Y = 2,500 − 500ε (equilibrium Y = 2,000 at ε = 1.0).

After ΔG = 100, multiplier = 1/(1−MPC) = 1/0.25 = 4; IS* intercept rises by 100 × 4 = 400:

New IS*: Y = 2,900 − 500ε

At ε = 1.0 (fixed): Y_IS = 2,900 − 500 = 2,400

Step 4 — Money supply must expand to keep ε = ē = 1.0.

For the LM* to support Y = 2,400 at i = i*, the central bank has sold foreign reserves (intervened) → M expanded endogenously. New LM* is vertical at Y = 2,400.

\[\Delta Y = 2,400 - 2,000 = \mathbf{+400}\]

This equals the full IS* multiplier (ΔG/(1−MPC) = 100/0.25 = 400), confirming fiscal policy has full multiplier effect under fixed rates.

Step 5 — Compare with closed economy.

In a closed economy, a rise in G would raise i, crowding out investment (the LM curve would rise along the fixed LM). Under fixed rates with open capital, no crowding out occurs because i is pinned at i* and the money supply expands to accommodate — the full Keynesian multiplier is restored.

Common Misconception

Misconception: "Under a fixed exchange rate, the central bank can still conduct independent monetary policy as long as it has enough foreign reserves."

Correction: This is only temporarily true. A central bank can defend a peg by running down reserves, but this is unsustainable once reserves are exhausted — a currency crisis results (see Mexico 1994, Thailand 1997, Argentina 2001). More fundamentally, the Mundell-Fleming logic is that any monetary expansion that lowers i below i* will trigger capital outflows and depreciation pressure, requiring an equal and opposite reserve intervention. The only sustainable path is accepting M as endogenous. The impossible trilemma (M20.L04) formalises this: you cannot simultaneously have a fixed rate, free capital mobility, AND independent monetary policy.

Practice Prompts

  1. Conceptual: Under a fixed exchange rate, what happens to a country's foreign exchange reserves when it attempts a monetary expansion? Trace the sequence of events.

→ Answer: Monetary expansion (M↑) → LM* shifts right → i tends to fall below i* → capital outflows (investors move money abroad for higher returns) → domestic currency depreciates → central bank must sell foreign reserves (buy domestic currency) to defend the peg → domestic M contracts back to original level. Net result: foreign reserves fall and M is unchanged. The monetary expansion is fully reversed by reserve outflows.

  1. Numerical: An economy has fixed rate ē = 2.0, initial IS*: Y = 4,000 − 600ε, and initial LM* at Y = 2,800. Government spending rises by ΔG = 50 with MPC = 0.6. Calculate: (a) the IS* multiplier; (b) the new IS* equation; (c) new Y at ε = ē = 2.0 under fixed rates.

→ Answer: - (a) Multiplier = 1/(1−MPC) = 1/0.4 = 2.5; IS* intercept rises by 50 × 2.5 = 125 - (b) New IS*: Y = (4,000 + 125) − 600ε = 4,125 − 600ε - (c) At ε = 2.0: Y = 4,125 − 600(2.0) = 4,125 − 1,200 = 2,925 - ΔY = 2,925 − 2,800 = +125 (equals the IS* multiplier × ΔG, confirming full effectiveness)

  1. Application: China maintained a fixed (or tightly managed) exchange rate against the USD for much of the 2000s. Using Mundell-Fleming, explain why this constrained the PBOC's ability to conduct independent monetary policy, and how China managed this tension.

→ Answer: Under a fixed USD/RMB rate and free capital mobility, the PBOC would lose monetary independence (Mundell-Fleming: i locked to i* via the peg). China resolved this by restricting capital mobility — maintaining capital controls (the third corner of the trilemma). This allowed the PBOC to set domestic interest rates independently while managing the exchange rate. The cost was that Chinese firms and households faced restrictions on cross-border investment. As China liberalised its capital account incrementally, maintaining the peg became increasingly difficult, leading to managed appreciation from 2005 and greater flexibility since 2015.

Visual — Policy Under Fixed Exchange Rates

(a) Monetary expansion is neutralised Output, Y Exchange rate, ε IS* LM₀* LM₁* ē Reserve intervention snaps LM* back to keep ε = ē. (b) Fiscal expansion is effective Output, Y Exchange rate, ε IS₀* IS₁* LM₀* LM₁* ē To defend the peg, reserve inflows expand money supply so LM* follows IS* right.

Figure: Under fixed exchange rates, monetary expansion is offset by reserve intervention, so output does not change. Fiscal expansion is effective because defending the peg forces the money supply to expand alongside the rightward IS shift.*

Further Resources