Working of Fixed Exchange Rate in Mundell-Fleming Model

Under Fixed ER, the Central Bank buys or sells the domestic currency for foreign currency at a pre-determined price.

For example:

1$ = Rs. 100 → Announced/Fixed ER in India

1$ = RS. 150 → Equilibrium ER → ER in Forex Market

Equilibrium ER is at point E₁

Reason: at point E₁ : IS = LM₁ Equilibrium

ER => 1 $ = RS. 150

But Central Bank fixed ER at => 1$ = RS. 100

^..^. (i) Equilibrium ER > Fixed ER

In such a situation the arbitrageur will buy Rupee in Forex market and then sell it in India and earn a profit.

He will buy Rs. 300 for $ 2 in Forex market and sell Rs. 300 in India for $ 3, and earn profit = $1.

When Central Bank buys Rs. from arbitrageur, that is,

When he sells Rs. 300 in India, to the Central Bank the money supply in India will increase,

Result:

LM curve will shift to the right from LM₁ to LM₂ and ER will fall to the fixed ER, that is from є₂ to є₁ (Fig. 18.5)

(ii) Similarly, if Equilibrium ER < Fixed ER vice versa will happen. (Fig. 18.6)

Arbitrageur will buy rupee Rs. 100 from India from Central Bank for $ 1 and sell it in the world market.

Result:

Money supply in India will fall.

LM curve will shift to the left from LM₁ to LM₂.

ER will increase and become equal to Fixed ER (є₁) (Fig. 18.6)