Question

Please comment the following sentences:
i) In the Mundell-Fleming setup, the increase in pessimism from consumers and firms in

the euro area affects GDP more severely than in a scenario of absence of a monetary union.

Answer 1

Mundell Fleming model is also known as IS LM Bop model which is an extension of IS LM model in to an open economy. This model explains the relation between interest rate, exchange rate and output. The concept of impossible trinity used here. There is flexible exchange rate system shows that it was mainly determined through market forces alone. The firms and people anticipated that the money supply will decrease in future. This will affect the economy very badly. This fill in money supply will increase the interest rate relative to global interest rate. This reduce the capital outflows will increase the real exchange rate and also shift the IS curve to left. The fall in the rate of global interest rate, shift the Bop curve downward also low level of capital outflows to foreign market. This will appreciate the domestic currency and dampen the net exports.
The pessimistic behaviour of the people makes this bad and good accept of the system. The flexible exchange rate makes the anticipated behaviour among the people and firms. These factors will affect the GDP of the country and retards the growth. The pessimistic behaviour of the people, reduce the investment attitude of the firms. They already believe that the interest rate and exchange rates will fall in future. This may leads to the fall in investment and the overall economic output also. If there is an absence of monetary authority will create this entire problem. So this occurred in a flexible exchange market system with free capital mobility. Under his circumstances the domestic rate is exogenously determined by the world interest rate. So this unanticipated attitude f the consumers and the firms will affect the future economy also.