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Lesson M20.L03: Mundell-Fleming Under Floating Exchange Rates

Module: Open Economy Macroeconomics Part I Level: intermediate Duration: 30 minutes Learning Objective: Explain why fiscal policy is crowded out by exchange rate appreciation under floating exchange rates. Data as of: 2024 Provenance: RBA Exchange Rate Research | MIT OCW 14.02

Explanation

Under a floating exchange rate regime, the exchange rate e is determined freely by supply and demand in the foreign exchange market. The central bank does not intervene to defend any particular rate. This changes the policy transmission mechanism entirely compared to the fixed-rate case (M20.L02).

Fiscal policy under floating exchange rates — fully crowded out.

  1. Government increases spending (G↑) → IS* shifts right.
  2. Y tends to rise → i rises above i* momentarily.
  3. With i > i*, capital inflows surge (investors attracted by higher domestic returns).
  4. Capital inflows increase demand for domestic currency → e appreciates (ε rises).
  5. Higher ε → NX falls (exports more expensive, imports cheaper).
  6. Falling NX shifts IS* back left toward its original position.
  7. The exchange rate appreciation perfectly offsets the fiscal expansion. Net effect on Y: approximately zero.

This is the "exchange rate crowding out" mechanism: fiscal expansion crowds out net exports rather than investment (as in the closed economy). The IS* curve returns to the LM* vertical line.

Monetary policy under floating exchange rates — fully effective.

  1. Central bank expands money supply (M↑) → LM* shifts right → Y rises.
  2. i falls below i* → capital outflows.
  3. Capital outflows reduce demand for domestic currency → e depreciates (ε falls).
  4. Lower ε → NX rises → IS* shifts right, amplifying the expansion.
  5. New equilibrium: Y is higher than the initial LM* shift alone would suggest. Net effect on Y: large and positive.

Summary under floating exchange rates: - Fiscal policy: ineffective (crowded out via exchange rate appreciation → NX↓) - Monetary policy: fully effective (amplified via exchange rate depreciation → NX↑)

This is the complete reversal of the fixed-rate result.

Australian context. Australia has operated a floating exchange rate since December 1983. The RBA's monetary policy is therefore effective: a cash rate rise appreciates the AUD, reducing import prices (lowering inflation directly) and reducing NX (dampening aggregate demand). Fiscal policy, by contrast, faces exchange rate crowding out — although in Australia's open commodity-exporting economy, fiscal multipliers are empirically modest for this and other reasons.

Notation: - ε = real exchange rate (higher = more appreciated; AUD rises in value) - NX = net exports; IS* shifts left when ε rises, right when ε falls - LM* shifts right when M rises (monetary expansion), left when M falls - Under floating, ε adjusts freely; under fixed, ε = ē is held constant

Worked Example

Question: Use the IS*-LM* model to trace the full effect of a fiscal expansion (ΔG = 200) under floating exchange rates. The economy has: IS*: Y = 5,000 − 800ε; LM* pins Y = 3,400 (at i = i* = 4%). MPC = 0.75.

Step 1 — Initial equilibrium.

From LM*: Y = 3,400

From IS*: 3,400 = 5,000 − 800ε → 800ε = 1,600 → ε = 2.0

Initial equilibrium: (Y = 3,400, ε = 2.0)

Step 2 — Fiscal multiplier shifts IS*.

\[\text{IS* shift} = \frac{\Delta G}{1 - MPC} = \frac{200}{0.25} = 800\]

New IS* (before exchange rate adjustment): Y = 5,800 − 800ε

Step 3 — Under floating: LM* is unchanged (no intervention), so Y stays at 3,400.

From new IS* at Y = 3,400:

\[3,400 = 5,800 - 800\varepsilon\]
\[800\varepsilon = 5,800 - 3,400 = 2,400\]
\[\varepsilon = \frac{2,400}{800} = 3.0\]

New equilibrium: (Y = 3,400, ε = 3.0)

Step 4 — Interpret.

  • Y is unchanged at 3,400 — fiscal expansion has zero effect on output.
  • ε rose from 2.0 to 3.0 — the AUD appreciated by 50%.
  • The appreciation reduced NX, completely offsetting the rise in G.

Step 5 — Decompose the demand change.

Original G = baseline. New G = baseline + 200. Rise in domestic demand = +200.

Fall in NX due to appreciation: The IS* curve has slope dY/dε = −800, meaning each unit rise in ε reduces Y by 800. The exchange rate rose by Δε = 1.0, implying the NX channel reduced Y by: 800 × 1.0 = 800.

But the fiscal multiplier only raised the IS* intercept by 800 (= 200/0.25). These are equal and opposite:

\[\underbrace{+800}_{\Delta G \text{ multiplier}} - \underbrace{800}_{\Delta \varepsilon \times 800} = 0\]

Perfect crowding out via NX: the fiscal expansion of 200 (with multiplier 800 in Y-space) is exactly offset by exchange rate appreciation (Δε = 1.0 × slope 800 = 800 in Y-space).

Step 6 — Now contrast: monetary expansion of ΔM that shifts LM* right by 400 (Y rises from 3,400 to 3,800).

New LM*: Y = 3,800

IS* unchanged: 3,800 = 5,000 − 800ε → 800ε = 1,200 → ε = 1.5

The AUD depreciated (ε fell from 2.0 to 1.5) → NX rose → aggregate demand amplified. Monetary expansion is effective under floating rates.

Common Misconception

Misconception: "Fiscal policy always stimulates the economy; exchange rate effects are secondary and minor."

Correction: In the Mundell-Fleming model with perfect capital mobility and a floating exchange rate, fiscal crowding out via the exchange rate is complete — not minor. The mechanism is: G↑ → i↑ → capital inflows → AUD↑ → NX↓ by exactly as much as G rose. Empirically, this is especially relevant for small open economies like Australia where capital mobility is high. The exchange rate channel operates quickly (financial markets react within hours) while fiscal spending takes months to flow through. Government economists are aware of this: Australian fiscal stimulus is most effective during global downturns when capital mobility is disrupted or the AUD depreciates from risk-off sentiment (as in 2008–09 GFC stimulus).

Practice Prompts

  1. Conceptual: Under floating exchange rates, why does monetary expansion increase output while fiscal expansion does not? Trace the NX channel for each policy.

→ Answer: Monetary expansion (M↑) → i falls → capital outflows → AUD depreciates → NX rises → IS* shifts right → Y rises. The NX channel amplifies the monetary policy. Fiscal expansion (G↑) → Y tends to rise → i rises → capital inflows → AUD appreciates → NX falls → IS* shifts back left → Y returns to original. The NX channel exactly offsets fiscal policy. The key difference: monetary policy moves i (affecting capital flows and hence the exchange rate in a reinforcing direction), while fiscal policy also moves i but the exchange rate response acts as a countervailing force on demand.

  1. Numerical: IS*: Y = 6,000 − 1,000ε; initial LM* pins Y = 4,000. (a) Find the initial exchange rate ε₀. (b) If monetary expansion shifts LM* right to Y = 4,500, find the new exchange rate ε₁. (c) Calculate the change in ε and interpret.

→ Answer: - (a) 4,000 = 6,000 − 1,000ε₀ → 1,000ε₀ = 2,000 → ε₀ = 2.0 - (b) 4,500 = 6,000 − 1,000ε₁ → 1,000ε₁ = 1,500 → ε₁ = 1.5 - (c) Δε = 1.5 − 2.0 = −0.5: the exchange rate depreciated (AUD fell in value by 0.5 units). This depreciation raised NX, which shifted IS* rightward, supporting the higher Y = 4,500. Monetary expansion under floating rates is thus amplified by exchange rate depreciation.

  1. Application: During 2022–23, the RBA raised the cash rate by 4.25 percentage points. In theory (Mundell-Fleming), this should have appreciated the AUD. In practice, the AUD depreciated against the USD. What factors could explain this divergence from Mundell-Fleming predictions?

→ Answer: Mundell-Fleming assumes the world interest rate i* is fixed. In 2022–23, the US Federal Reserve was also raising rates aggressively (by ~5.25pp), matching or exceeding the RBA's tightening. The interest rate differential (RBA rate minus Fed rate) actually narrowed or turned negative — reducing the attractiveness of AUD-denominated assets. Additionally: (i) global risk-off sentiment caused flight to USD safety; (ii) Australia's commodity terms of trade fell from their 2022 peak (iron ore price correction), reducing AUD demand; (iii) the USD strengthened globally, not just against AUD. These factors overwhelmed the textbook appreciation prediction, illustrating that Mundell-Fleming is a simplified model — uncovered interest parity involves expected future exchange rates, risk premia, and global USD dynamics not captured in the basic framework.

Visual — Policy Under Floating Exchange Rates

(a) Fiscal expansion is crowded out Output, Y Exchange rate, ε IS₀* IS₁* Appreciation shifts net exports down, so IS* returns and \(\Delta Y = 0\). LM* (b) Monetary expansion raises output Output, Y Exchange rate, ε IS₀* IS₁* LM₀* LM₁* Monetary expansion shifts LM* right, depreciates the currency, and shifts IS* right. Net result: \(\Delta Y > 0\).

Figure: Under floating exchange rates, fiscal expansion is offset by appreciation and leaves output unchanged, while monetary expansion depreciates the currency, shifts IS right, and raises output.*

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