Question

Q1)Examine the effects of a decrease in foreign output and foreign interest rate underflexible-exchange rate regime when the goal of the central bank is to achieve outputstability (Hint: Use Mundell-Fleming model).What happens to the components ofdemand?

Answer 1

Q1) A Mundell-Fleming model for a small economy under flexible exchange rate regime and perfect capital mobility assumes that domestic prices remain fixed, but th enchange rate is totally flexible. Central Bank does not intervene in the foreign exchange market and the exchange rate adjustment take place itslef, bringing the supply and emand to equilibrium. It assumes at only when the domestic interest rate = foreign/world interest rate is when the balance of payments is in equilibrium i.e. BP = 0. The Mundell Fleming model is an extension of the IS-LM model and also known asIS-LM-BP model. The IS curve depicts the goods and services market where Y = production = demand for goods/services = Consumption (C) + Investment (I) + Govt spending (G) + Net exports (NX). The LM curve depicts the money market where M/P = L (i,Y) and BP is the balance of Payments. Take a look at fig 1 which is in equilibrium for a floating exchange rate regime.

When the foreign interest rate decreases i.e. i_d> i_f , there will be unlimitated inflow of capital which will cause the appreciation of the exchange rate that will reduce the exports, increase the imports, and hence, lead to a fall in the net exports (NX) component of demand. This fall in NX will cause a leftward shift of the IS curve, leading to a decrease in the national income/outout and decrease in the interest rate till it becomes equal to the new foreign interest rate. The decrease in foreign capital also implies that the foreign exports have become more expensive due to a sudden appreciation of their exchange rate, which leads to redcution in their output and interest rate. due to the shift of their IS curve. So the effect of these decreases in foreign output and interest rate will have a similar effect on the domestic interest rate and output and both the foreign and the domestic exchange rate increases under the flexible exchange rate regime. This can be seen in fig 2.

Now, as the Central Bank wants to achieve output stability, it will enforce a policy that increases the output back to its prior stable level. So, the Central Bank will execute an expansionary monetary policy as under a floating exchange rate regime, only the monetary policy can change the national income/output. The Expansionary monetary policy under Flexible Exchange Rate regime is highly effective in increasing the level of national income or output. Let there be an initial equilibrium 'E' . Now, this increase in domestic money supply will cause a depreciation ordecrease in the exchange rate of the domestic currency. Increases in nominal quanity of money supply , assuming domestic prices remain constant, there will be excess supply of the real money balances, LM curve will shift to teh right, causing the aggregate income to rise. The new equilibrium (E') is restored at the original exchange rate, the rate of interest reduces below the foreign interest rate level. This will lead to capital outflows from domestic country which will decrease the supply of foreign exchange, resulting in depreciation of domestic currency. This devaluation will make the exports of the domestic country relatively cheaper and the imports more expensive than before. This will result in increase in exports, fall in imports, leading tto a larger net export (NX) component of demand. This increase in NX will lead to an increase in the aggregate demand , causing the IS curve to shift rightwards. Also, when the int rate falls, it would put more money into teh hands of the consumers which would increase consumer spending i.e. "C' component and consequently 'I' component of AD which would increase, further supporting the Is curve to shift that would restore the equilibrium. This will continue shifting to the right until the equilibrium of the goods market and money market takes place at the rate of interest which is equal to the forein interest rate. So, the new equilibrium is at Point E" where the new LM and IS curves intersect and i_{d =} i_f and at this new equilibriumlevel, teh level of national income /output Y₁ is greater than the initial income level Y₀. Take a look at fig 3.