7 - The three-equations model for the open economy

Summary

The legacy of the Mundell-Fleming model

Until now an assumption has been made that the economy under consideration is a closed one, and is therefore not open to international trade and international flows of finance. This is deeply implausible especially when the actual economy being considered is that of the UK, or of any individual country in Europe. In practice, the choice of maintaining the economy closed in its modelling is dictated by the fact that abandoning the LM curve has very awkward implications for an open economy model, which has to replicate the results of the venerable Mundell-Fleming one. The latter can be described as the open economy extension of the IS-LM, but translating it into a diagram that would dispense with an LM curve that represents changes in the domestic money supply has proven a challenge. In their 2006 book, Carlin and Soskice shied away from such a challenge and reverted to the Mundell-Fleming in their open economy chapters, thereby reinstating the implausible LM curve. This was altered in the 2014 book (Carlin & Soskice 2014) but, as it will be argued below, the result is not altogether satisfactory. The unavoidable challenge is given by the fact that the Mundell-Fleming diagram is invariably simpler and more intuitive than any of its replacements. So, it comes to a choice: textbooks (e.g., Gärtner 2014) which place the treatment of the open economy at their centre, opt to retain that older model at the price of an implausibly obsolete diagrammatic representation of the conduct of monetary policy. Textbooks instead that place greater weight on a plausible and accurate description of the latter, have to compromise with awkward diagrams in their open economy settings. This is the route taken by Carlin and Soskice (2014) and so will it be the case in what follows here, in the hope of doing something marginally less awkward. But it has to be understood that the aim is to replicate the results of the Mundell-Fleming which have to be kept in mind, and a thoroughly clear rendition of which can be found in Gärtner (2014).