This lesson explains the Mundell Fleming Model under Floating Exchange Rate. This lesson further explains the effectiveness Monetary Policy and Trade Policy under Flexible Exchange Rate. It is important for the 4th semester macroeconomics BBE students of Delhi University. It is relevant for other courses like BBA, Economics hons, for the graduation and post graduation level and for competitive exams like CUET Economics, IAS economics optional, Indian Economic Service and the NET JRF Economics aspirants.

Floating Exchange Rate means that the Exchange Rate is allowed to fluctuate in response to changing economic conditions.

Monetary Policy: Monetary Policy means change in the Money Supply by the Central Bank. Suppose there is expansionary monetary policy and the Central Bank increases the Money Supply. This leads to the rightward shift of the LM curve. Now there is excess supply of money and this creates portfolio disequilibrium, that means people are holding more money than they need and they will start demanding more bonds, this leads to an increase in the bond prices and decline in the interest rate. Now, the domestic interest rate is lower than the foreign interest rate and this leads to capital outflow. Thus, the supply of domestic currency increases in the international market and this creates downward pressure and the domestic currency depreciates. This makes exports cheaper and thus there will be an increase in the exports of the country leading to an increase in the income.

Hence, in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate. Thus, monetary policy is effective under Floating Exchange Rate.


Trade Policy: Suppose that the government decreases the demand for imported goods by imposing import quota or import tariff. This leads to an increase in the Net Exports and the Net Exports curve shifts towards the right, as a result Aggregate demand increases. This leads to an increase in income by shifting the Open economy IS curve. This leads to an increase in Money demand leading to increase in the interest rate. Now the domestic interest rate becomes greater than the foreign interest rate, so there will be capital inflow. This means more demand for the domestic currency. As a result, the nominal exchange rate increases which leads to appreciation of the domestic currency and thus the net exports reduces leading to a reduction in the Net Exports and finally declining income.

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