The Mundell–Fleming model is the IS–LM model for a small open economy. It takes the price level as given and then shows what causes fluctuations in income and the exchange rate.
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The Mundell–Fleming model shows that fiscal policy does not influence aggregate income under floating exchange rates. A fiscal expansion causes the currency to appreciate, reducing net exports and offsetting the usual expansionary impact on aggregate income. Fiscal policy does influence aggregate income under fixed exchange rates.
The Mundell–Fleming model shows that monetary policy does not influence aggregate income under fixed exchange rates. Any attempt to expand the money supply is futile, because the money supply must adjust to ensure that the exchange rate stays at its announced level. Monetary policy does influence aggregate income under floating exchange rates.
If investors are wary of holding assets in a country, the interest rate in that country may exceed the world interest rate by some risk premium. According to the Mundell–Fleming model, an increase in the risk premium causes the interest rate to rise and the currency of that country to depreciate.
There are advantages to both floating and fixed exchange rates. Floating exchange rates leave monetary policymakers free to pursue objectives other than exchange-rate stability. Fixed exchange rates reduce some of the uncertainty in international business transactions, and they remove the negative spillover effects to other regions of the country that result from provincial-level fiscal policies that are undertaken with a flexible exchange rate.
When deciding on an exchange-rate regime, policymakers are constrained by the fact that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy.