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Chapter 8The Mundell-Fleming ModelMundell [108]—Fleming [54] is the IS-LM model adapted to the openeconomy. Although the framework is rather old and ad hoc the basicframework continues to be used in policy related research (Williamson [132],Hinkle and Montiel [107], MacDonald and Stein [98]). The hallmarkof the Mundell-Fleming framework is that goods prices exhibit stickinesswhereas asset markets–including the foreign exchange market–are continuously in equilibrium. The actions of policy makers play amajor role in these models because the presence of nominal rigiditiesopens the way for nominal shocks to have real effects. We begin with asimple static version of the model. Next, we present the dynamic butdeterministic Mundell-Fleming model due to Dornbusch [39]. Third, wepresent a stochastic Mundell-Fleming model based on Obstfeld [111].8.1 A Static Mundell-Fleming ModelThis is a Keynesian model where goods prices are Þxed for the durationof the analysis. The home country is small in sense that it takesforeign variables as Þxed. All variables except the interest rate are inlogarithms.Equilibrium in the goods market is given by an open economy versionof the IS curve. There are three determinants of the demand fordomestic goods. First, expenditures depend positively on own income ythrough the absorption channel. An increase in income leads to higher229