Evaluate the theoretical properties of the Mundell-Fleming model, also known as the open-economy IS-LM model. Under a system of fixed exchange rates and perfect capital mobility, which macroeconomic policy loses its effectiveness entirely?

💡 Solution & Explanation

Under fixed exchange rates and perfect capital mobility, monetary policy becomes entirely ineffective for influencing domestic output. Any attempt by the central bank to expand the money supply lowers domestic interest rates, triggering massive capital outflows that threaten to depreciate the currency. To maintain the fixed exchange rate peg, the central bank must intervene by purchasing its currency, which automatically reverses the initial monetary expansion. Fiscal policy, conversely, becomes highly potent under these specific structural conditions.