Difficulty: Advanced | Prerequisites: Ch. 1–12 notes. You must be comfortable with IS-LM and the open-economy model before starting this material.
Source: Mankiw, Macroeconomics, 9th Edition, Chapters 13–14 (plus advanced topics as schedule allows)
Tags: Mundell-Fleming, open economy IS-LM, fixed exchange rate, floating exchange rate, impossible trinity, aggregate supply, Phillips curve, NAIRU, expectations, sacrifice ratio, supply shock, EC305
Chapter 13 takes the IS-LM model and opens the economy to international capital flows and exchange rates (the Mundell-Fleming model). The central result is that the effectiveness of fiscal and monetary policy depends entirely on whether the exchange rate is fixed or floating. Chapter 14 completes the AD-AS framework by building the aggregate supply side, introducing the Phillips curve and the role of expectations. Together, these chapters give you the complete toolkit for analysing short-run macroeconomic policy. The advanced topics (consumer behaviour, investment, government debt, stabilisation policy) extend the framework but may not all be covered depending on the class schedule.
Under floating exchange rates, monetary policy is powerful and fiscal policy is impotent (crowded out through the exchange rate). Under fixed exchange rates, the reverse holds. The short-run aggregate supply curve slopes upward because of sticky wages, sticky prices, or imperfect information. The Phillips curve is the dynamic version of the AS curve, linking inflation to unemployment. In the long run, the economy returns to the natural rate regardless of policy.
Mundell-Fleming Model
The open-economy version of IS-LM for a small open economy with perfect capital mobility. It uses the IS* and LM* curves, with the exchange rate replacing the interest rate as the key adjusting variable.
Small Open Economy
An economy too small to affect the world interest rate. It takes the world interest rate r* as given. Think of it as a price-taker in the global capital market.
Perfect Capital Mobility
The assumption that domestic and foreign bonds are perfect substitutes, so the domestic interest rate must equal the world rate: r = r*.
Floating Exchange Rate
A regime where the exchange rate is determined by supply and demand in the foreign exchange market. The central bank does not intervene.
Fixed Exchange Rate
A regime where the central bank commits to buying or selling domestic currency to maintain the exchange rate at a target level. The money supply becomes endogenous (adjusts automatically to maintain the peg).
Impossible Trinity (Trilemma)
A country cannot simultaneously have all three of: a fixed exchange rate, free capital mobility, and an independent monetary policy. It must give up one.
Short-Run Aggregate Supply (SRAS)
The relationship between the price level and the quantity of output supplied in the short run. It slopes upward because some prices or wages are sticky, or because firms have imperfect information about the aggregate price level.
Phillips Curve
The inverse relationship between inflation and unemployment in the short run. It is the dynamic counterpart of the SRAS curve. Higher inflation is associated with lower unemployment, and vice versa.
Expected Inflation (π^e)
The rate of inflation that workers and firms expect when setting wages and prices. It shifts the Phillips curve: higher expected inflation shifts the curve upward.
NAIRU (Non-Accelerating Inflation Rate of Unemployment)
Another name for the natural rate of unemployment. When unemployment is at NAIRU, inflation is stable. Below NAIRU, inflation accelerates; above it, inflation decelerates.
Adaptive Expectations
The assumption that people form their inflation expectations based on recently observed inflation. If inflation was 3% last year, they expect 3% this year. This makes the Phillips curve shift gradually.
Rational Expectations
The assumption that people use all available information to form their expectations. Anticipated policy changes are built into expectations immediately, so only unexpected policy has real effects.
Sacrifice Ratio
The percentage of a year's GDP that must be forgone to reduce inflation by 1 percentage point. In simple terms, it measures how much economic pain is required to bring inflation down.
Supply Shock
An event that shifts the SRAS curve. An adverse supply shock (e.g. an oil price increase) shifts SRAS left, raising prices and reducing output (stagflation).
Ricardian Equivalence (Advanced)
The proposition that a tax cut financed by government borrowing does not stimulate consumption, because forward-looking consumers save the tax cut to pay the future taxes needed to service the debt.
Permanent Income Hypothesis (Advanced)
Milton Friedman's theory that consumption depends on permanent (long-run average) income, not current income. Temporary income changes have little effect on spending.
Tobin's q (Advanced)
The ratio of the market value of installed capital to its replacement cost. When q > 1, firms have an incentive to invest because the market values capital above what it costs to build.
This is IS-LM for a small open economy with perfect capital mobility
The domestic interest rate is pinned at the world rate: r = r*
Two curves in (e, Y) space (where e is the nominal exchange rate):
IS*: Y = C(Y - T) + I(r*) + G + NX(e). Slopes downward because a higher e (appreciation) reduces NX and Y.
LM*: M/P = L(r*, Y). Vertical, because with r fixed at r*, Y is determined entirely by the money supply.
Under floating exchange rates:
Fiscal expansion (IS* shifts right): raises e (appreciation), which crowds out NX, leaving Y unchanged. Fiscal policy is completely ineffective.
Monetary expansion (LM* shifts right): increases Y, lowers e (depreciation), raises NX. Monetary policy is powerful.
The exchange rate does all the adjusting.
Under fixed exchange rates:
The central bank must keep e at its target by buying/selling currency, which changes M.
Fiscal expansion (IS* shifts right): puts upward pressure on e. To prevent appreciation, the central bank buys foreign currency, increasing M. LM* shifts right to match. Y rises. Fiscal policy is powerful.
Monetary expansion: shifts LM* right, putting downward pressure on e. To prevent depreciation, the central bank sells foreign reserves, reducing M back to its original level. LM* returns to its original position. Monetary policy is completely ineffective.
The impossible trinity: you can see why a fixed exchange rate removes monetary independence.
Three models of why SRAS slopes upward:
Sticky-wage model: nominal wages are set in advance. When P rises unexpectedly, real wages fall, firms hire more, output rises.
Sticky-price model: some firms keep prices fixed. When demand rises, they sell more at the old price, so output rises with P.
Imperfect-information (Lucas islands) model: firms confuse a general price rise for a rise in their own relative price, so they produce more.
All three yield the same SRAS curve: Y = Y_natural + α(P - P^e), where α > 0
When P > P^e (prices higher than expected), output exceeds its natural level
When P = P^e, output is at its natural level
In the long run, expectations adjust so P = P^e and Y = Y_natural (LRAS is vertical)
The Phillips curve is the dynamic version of the SRAS equation: π = π^e - β(u - u_n) + ν
π = actual inflation
π^e = expected inflation
u = unemployment rate, u_n = natural rate
ν = supply shock
β > 0: below-natural unemployment pushes inflation above expected inflation
With adaptive expectations (π^e = last period's π), the Phillips curve becomes: π = π_(-1) - β(u - u_n) + ν
To reduce inflation, you must push unemployment above the natural rate (a recession). The sacrifice ratio measures the cost.
A favourable supply shock (ν < 0) reduces inflation without raising unemployment.
An adverse supply shock (ν > 0, e.g. oil price spike) raises inflation and unemployment simultaneously (stagflation).
Permanent Income Hypothesis (Friedman): consumption depends on average lifetime income, not current income. Temporary tax cuts have little effect on spending.
Life-Cycle Hypothesis (Modigliani): people smooth consumption over their lifetime, saving during working years and dissaving in retirement.
Ricardian Equivalence: a tax cut financed by borrowing does not change consumption, because rational consumers save the windfall to pay future taxes. Strong assumptions (perfect credit markets, no liquidity constraints, infinite horizons or bequest motive) limit its practical relevance.
Tobin's q theory of investment: firms invest when the market value of capital exceeds its replacement cost (q > 1). Links the stock market to investment decisions.
Stabilisation policy debates: rules vs discretion, time inconsistency, central bank independence, the Taylor rule as a monetary policy guide.
Government debt: the long-run fiscal constraint, debt dynamics (debt grows when the interest rate exceeds the growth rate), and intergenerational redistribution.
Mundell-Fleming IS (open economy goods market)*
Y = C(Y - T) + I(r^*) + G + NX(e)Mundell-Fleming LM (open economy money market)*
\frac{M}{P} = L(r^*, Y)With r fixed at r*, this pins down Y for a given M/P. The LM* curve is vertical in (e, Y) space.
Short-Run Aggregate Supply
Y = \bar{Y} + \alpha(P - P^e)where Y-bar is natural output, α > 0, P^e is the expected price level.
Phillips Curve
\pi = \pi^e - \beta(u - u_n) + \nuWith adaptive expectations (π^e = π_(-1)):
\pi = \pi_{-1} - \beta(u - u_n) + \nuSacrifice Ratio
\text{Sacrifice ratio} = \frac{\text{Cumulative percentage loss of GDP}}{\text{Reduction in inflation (percentage points)}}Typical estimates: 3 to 5 (i.e. reducing inflation by 1 point costs 3–5% of a year's GDP).
Okun's Law (rule of thumb)
\Delta u \approx -0.5 \times (\text{\% change in real GDP} - 3\%)A useful approximation linking changes in unemployment to deviations of GDP growth from its trend.
Key Diagrams
Mundell-Fleming (e, Y) space: IS* slopes down, LM* is vertical. Under floating rates, show fiscal expansion (IS* right, e up, Y unchanged) and monetary expansion (LM* right, e down, Y up). Under fixed rates, show how LM* adjusts endogenously.
SRAS-LRAS-AD: P on vertical axis, Y on horizontal. LRAS vertical at Y-bar. SRAS slopes up. AD slopes down. A demand shock shifts AD; a supply shock shifts SRAS. In the long run, the economy returns to LRAS.
The Phillips curve: π on vertical axis, u on horizontal. The curve slopes downward. An increase in π^e shifts the entire curve up. A supply shock shifts it up or down.
The Mundell-Fleming results explain why the European Monetary Union (the euro) required countries to give up independent monetary policy. With a fixed exchange rate (the common currency) and free capital movement, the impossible trinity means each member state cannot set its own interest rates.
The Phillips curve was central to the debate over the 2021-2023 inflation surge. As unemployment fell sharply during the post-pandemic recovery, inflation rose, consistent with the Phillips curve mechanism. The subsequent disinflation raised questions about whether the sacrifice ratio would be as large as historical estimates suggested.
Oil price shocks in the 1970s are the textbook example of adverse supply shocks. OPEC's oil embargo shifted SRAS left, producing stagflation: rising prices and falling output simultaneously, a combination the Phillips curve predicts when ν > 0.
Students often think fiscal policy always works. In the Mundell-Fleming model with floating exchange rates, fiscal expansion is completely offset by exchange rate appreciation. The exchange rate regime matters enormously.
Students confuse the short-run and long-run Phillips curve. In the short run, there is a trade-off between inflation and unemployment. In the long run, the Phillips curve is vertical at the natural rate: you cannot permanently reduce unemployment by accepting higher inflation.
Students sometimes think reducing inflation is free. It is not. The sacrifice ratio tells you the real output cost. Under adaptive expectations, disinflation requires a recession. Under rational expectations, if the policy is credible, the cost may be lower (the "cold turkey" argument).
Students frequently mix up the effects of demand shocks and supply shocks. A negative demand shock reduces both output and the price level. A negative supply shock reduces output but raises the price level (stagflation). The policy response is different in each case.
⚠️ The Mundell-Fleming policy table is almost certainly on the exam. Know which policy (fiscal or monetary) is effective under which exchange rate regime, and be able to show it graphically.
⚠️ Be able to draw the SRAS-LRAS-AD diagram and show: (a) a demand shock and the short-run and long-run adjustment, (b) a supply shock and the policy dilemma it creates.
⚠️ Know the Phillips curve equation and be able to trace through what happens when the central bank tries to reduce inflation (disinflation): unemployment rises above the natural rate, and the sacrifice ratio measures the cost.
⚠️ Understand the difference between adaptive and rational expectations, and how each affects the cost of disinflation.
⚠️ Be able to explain the impossible trinity and give a real-world example (e.g. the eurozone, or China's managed exchange rate).
True or False: Under floating exchange rates in the Mundell-Fleming model, fiscal expansion raises output. (False; it appreciates the exchange rate and leaves Y unchanged.)
Fill in the blank: Under fixed exchange rates, monetary policy is ______ because the central bank must adjust M to maintain the peg. (Ineffective / impotent)
True or False: The long-run Phillips curve is vertical at the natural rate of unemployment. (True)
Fill in the blank: The SRAS equation is Y = Y-bar + α(P - ______). (P^e, expected price level)
True or False: An adverse supply shock reduces output and reduces the price level. (False; it reduces output but raises the price level.)
Q: In the Mundell-Fleming model with floating exchange rates, explain why a fiscal expansion does not raise output.
A: A fiscal expansion shifts IS* to the right. At the old exchange rate, the domestic interest rate would tend to rise above r*. This attracts foreign capital, increasing demand for the domestic currency. The exchange rate appreciates (e rises). The stronger currency reduces net exports, which offsets the fiscal stimulus exactly. Output is unchanged; only the composition of spending changes (more G, less NX).
Q: A small open economy with a fixed exchange rate decides to increase the money supply. What happens?
A: The central bank's attempt to increase M shifts LM* to the right, which would depreciate the exchange rate. But under a fixed rate, the central bank must sell foreign reserves and buy domestic currency to maintain the peg. This reduces M back to its original level. LM* returns to its original position. The policy has no lasting effect. This illustrates why fixed exchange rates and independent monetary policy are incompatible.
Q: The economy starts at the natural rate of unemployment with 4% inflation. The central bank wants to reduce inflation to 2%. Using the Phillips curve with adaptive expectations and a coefficient β = 0.5, how much extra unemployment is needed?
A: With adaptive expectations, π = π_(-1) - β(u - u_n). To reduce inflation by 2 percentage points, we need -β(u - u_n) = -2, so (u - u_n) = 2/0.5 = 4 percentage points of extra unemployment. This could be spread over multiple years (e.g. 2 points above natural for 2 years, or 4 points above natural for 1 year). The sacrifice ratio depends on Okun's law linking the extra unemployment to lost GDP.
Q: An adverse supply shock hits the economy (e.g. an oil price increase). Using the AD-AS diagram, show what happens in the short run and explain the policy dilemma.
A: SRAS shifts left. At the same AD curve, the short-run equilibrium has higher P and lower Y (stagflation). The policy dilemma: if the central bank accommodates the shock (shifts AD right to restore Y), it validates the higher inflation, which gets built into expectations. If it does nothing, the recession persists until wages and expectations adjust downward. If it contracts to fight inflation (shifts AD left), the recession deepens.
Q: Explain Ricardian equivalence and one reason it may not hold in practice.
A: Ricardian equivalence says a tax cut financed by government borrowing does not affect consumption, because rational consumers recognise the future tax liability and save the entire tax cut. It may not hold because: (a) many consumers are liquidity-constrained and cannot borrow against future income, so a tax cut relaxes their constraint; (b) consumers may have finite horizons and not care about taxes that fall on future generations; (c) consumers may not be fully rational or forward-looking.
The Mundell-Fleming model is the open-economy extension of IS-LM (Ch. 11–12). The key difference is that the world interest rate replaces the domestic interest rate as the anchor, and the exchange rate becomes the adjusting variable. The aggregate supply material in Ch. 14 completes the AD-AS framework begun in Ch. 10–12: AD comes from IS-LM, and AS comes from sticky wages/prices. The Phillips curve links directly to the natural rate of unemployment (Ch. 7), since the natural rate is the unemployment rate at which inflation is stable. The advanced topics on consumer behaviour and investment connect back to the components of the national income identity (Ch. 3): understanding what drives C and I at a deeper level refines the simple behavioural assumptions of the basic model.
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