Question

The Mundell-Fleming Model.
A small open economy is described by the following equations: C = 50 + .75(Y - T)
I = 200 - 20i
NX = 200 - 50E
M/P = Y - 40i
G = 200
T = 200
M = 3000
P=3

i* = 5

The government increases its spending by 50. How does the equilibrium in change if financial agents’ expectations change? (5 points)

Answer 1

Since there is no change in real money balances and equilibrium income remains constant. Therefore rise in the government spending will increase domestic interest rate. This will attracts capital inflows from abroad resulting in the appreciation of domestic currency. As shown in the above picture, exchange rate changes from 2 to 3.The appreciation of exchange rate makes exports to world costlier. So exports by exactly by the amount of increase in government spending ie 50. Thus equilibrium income remains constant and rise in the government spending is fully offset by fall in exports.