The Mundell Fleming model is usually taught in second year macroeconomics. It's the open economy version of the ISLM model.
This post is me disagreeing with Simon Wren-Lewis about teaching open economy macro (in textbooks and in the classroom). It is not a disagreement about open economy macroeconomics.
Simon says that the textbook Mundell Fleming model, in some circumstances (like a temporary increase in government spending), violates Uncovered Interest Parity.
I say that the textbook Mundell Fleming model always preserves Uncovered Interest Parity, but in some circumstances (like a temporary increase in government spending), violates model-consistent ("rational") expectations.
Big disagreement? Not really. But I think my way of looking at it is more intuitive.
The students already know the closed economy ISLM model.
I explain how the IS curve is different in an open economy. Changes in the real exchange rate will cause changes in demand for net exports, which cause the IS curve to shift.
I explain how the LM curve may be different in an open economy, depending on whether the central bank responds to changes in the exchange rate (for example, fixing the exchange rate).
I then explain the BP curve, and write down the equation: Canadian nominal (or real) interest rate = US nominal (or real) interest rate minus expected rate of nominal (or real) appreciation of the Loonie exchange rate. I then show how changes in expected rate of appreciation will shift the BP curve.
I then ask what determines the expected rate of appreciation? And reply "Hmmm, I don't know. Let's assume it's constant for now. But we might need to check back on that assumption if the model tells us the actual rate of appreciation will change."
A constant expected rate of appreciation of the exchange rate is only a rational expectation if the exchange rate follows a random walk (with drift). That's not a bad assumption, but it won't always work. But then no simple assumption always works.
In the case of a temporary increase in government purchases (and in other cases too), the model tells us that the actual exchange rate will first appreciate, then depreciate again when government purchases return to normal. If people know that the increase in government purchases is only temporary, and if they are smart enough to use the model to figure out how that will affect the future exchange rate, they will expect the exchange rate to depreciate in future. That causes the BP curve to shift up. (Whether that upward shift in the BP curve increases Aggregate Demand depends on how the central bank responds.)
Lots of other things can cause the expected rate of appreciation to change. So we need to teach this anyway.
The difference between Simon and me is this: in Simon's benchmark model the exchange rate is expected to revert to the mean (or trend) in the "next period"; in my benchmark model the exchange rate follows a random walk (plus drift), so is expected to be the same next period as this period (plus drift).
Just a quickie between admin and teaching.