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3.5 The IS–LM Model for an Open Economy

Having discussed the Keynesian approach to stabilization policy in the context

of the IS–LM model for a closed economy (sections 3.2–3.4), we next

consider the use of fiscal and monetary policy for stabilization purposes in an

open economy using a model first developed by Robert Mundell and Marcus

Fleming at the start of the 1960s (see Mundell, 1963; Fleming, 1962). As we

will discuss, the effects of a change in fiscal and monetary policy depend on

the degree of capital mobility and the type of exchange rate regime in existence.

We begin with a review of the main changes we need to incorporate in

extending the IS–LM model to an open economy.