Question

Consider the Mundell-Fleming model we have discussed in class for the small
open economy. Suppose that higher income implies higher imports and thus
lower net exports. That is, the net-exports function is
NX = NX(e, Y )
Examine the effects in a small open economy of a fiscal expansion on income
and the trade balance under the following exchange-rate regimes:
1. A floating exchange rate (5 points)
2. A fixed exchange rate (5 points)

Answer 1

1.

Floating exchange rates: Under this exchange rate regime, if there is higher income, demand for goods increases. The trade balance will be skewed, wherein there will be a trade deficit as the imports will rise and the exports would be comparatively less. The trade deficit will weaken the currency under floating exchange rate as imports will rise comparatively to the exports, because demand for the other countries currency increases, while demand for the local country's currency falls. Thus because of fiscal expansion the national product will rise, trade deficit increases as the exchange rate would depreciate and the inflation would increase.

2.

Fixed exhange rates: Under fixed exchange rate mechanism the exchange rate would be the same, thus there is a trade imbalance in this as well but because of increase in demand of foreign country's currency as imports rise, the central bank buys the domestic country's currency so as to reduce the supply and maintain the fixed exchange rate system. Thus in this the effect of fiscal expansion will be increase in the national product and trade balance is maintained so that the deficit is not that huge.