The
main purpose of the MundellFleming model is to determine
equilibrium income and how this income responds to economic policy
and shocks. It merges the foreign exchange market (FE), the goods
market (IS) and the money market (LM). Overall equilibrium obtains
when these three markets are in equilibrium. Viewed in a diagram,
equilibrium is where FE, IS and LM intersect.

The MundellFleming model refines the IS curve by tying down
two loose ends. The IS curve tells us that equilibrium income depends
on the interest rate. As long as we do not know the interest rate
(which is an endogenous variable) we have not really determined
income. Also, since the position of IS shifts when the exchange
rate moves, equilibrium income depends on the exchange rate too.
If we do not know the exchange rate (another endogenous variable),
we cannot determine income (even if we knew the interest rate).
The foreign exchange market and the money market, which the MundellFleming
model adds to the goods market, serve to determine the interest
rate and the exchange rate. This finally permits us to nail down
equilibrium income.

What if the three curves do not intersect in a common point?
Do not worry. They always do. The reason is that only two out of
these three curves are fixed by the policy maker and/or exogenous
variables. The position of the third curve depends on endogenous
variables as well. These endogenous variables always adjust so that
they move this third curve into the position where the other two
curves already intersect. So the third curve is actually redundant.
You may forget about it, for it is always where the other two curves
are, just as the tail is always where the dog is.

Which one is the third, redundant curve? And which are the
two we need to keep our eyes on? Well, that depends on whether we
operate under flexible exchange rates
or under fixed exchange rates.
Further reading on pp. 115ff. Click here for interactive applets featuring the MundellFleming model
