Evaluate the mechanics of the Mundell-Fleming model, also known as the open-economy IS-LM model. Under a regime of fixed exchange rates and perfect capital mobility, what is the consequence of monetary policy expansion?

💡 Solution & Explanation

Under the Mundell-Fleming framework with fixed exchange rates and perfect capital mobility, an expansionary monetary policy increases the money supply and lowers domestic interest rates below world levels, triggering massive capital outflows. To prevent the domestic currency from depreciating, the central bank must purchase its own currency using foreign reserves, which contracts the money supply back to its initial equilibrium. Consequently, monetary policy loses all independent potency for domestic stabilization under fixed exchange rates. Conversely, fiscal expansion is highly effective under these identical institutional conditions.