Question

1) Mundell – Fleming model and theory of optimum common currencies:
a) Assuming perfect capital mobility and flexible exchange rates, explain the impact on the Irish economy of a decrease in interest rates in the U.S. In your answer, clearly indicate the effect on income, rate of interest, balance of payments. (Show your answer with the help of an IS-LM-BP diagram and explain the mechanisms. Consider Ireland a small open economy with flexible exchange rates.
b) Are Monetary and Fiscal policies effective in the case of question (a)? Explain with graphs.
c) Discuss the notion of unholy trinity.

Answer 1

Part (a)

So starting with a case where there is a fall in the interest rates of the foreign country and hence it makes the home country an attractive place for the investors assuming that now the interest rates in the home country (Ireland) s more than the US. Now as there is perfect capital mobility and the exchange rates are flexible hence the BP curve is going to be perfectly horizontal and it doesn't budge from the position. Now if with the change in the rate of interest conditions in the US, the capital inflows for Ireland will occur. This will shift the IS curve to the right and the rate of interest witll increase in the home country. With this capital inflow the home country's currency will appreciate and the exports will fall. Considering that Ireland is a small country the Is curve will shift back to the original position from where it started as the IS curve will shift to original equilibrim. So the effect of change in interest rates of the US will have no effect on the equilibrim of home country. (Please follow the graph)

But also consider this with capital inflow the LM curve will shift to the right and with this rightward shift the interest rates will fall and with the fall in the interest rates the IS curve will also shift outwards (upwads) as the currency has depreciated. Although when the exports increases the imports are discourages which increases the prices for home country and hence the prices increases shifting the LM curve a little bit backward but not all the way leaving an all over rise in the output (Y) and no change in the interest rate(to reach BP equilibrim).

Part (b) Please follow the same graph

As seen above the monetary side does have a effect on the equilibrim where as the fiscal side doesn't have any effect on the equilibrim.

Again consider this, Imagine the equilibrim is at point E with expansion in the Fiscal policy the IS' is reached with the increase in interest rates at point E'. Now increase in the interest rates will cause the appreciation of the currency and this will shift the IS curve back to origical IS level and equilibrim to E as the exports will fall. Hence fiscal policy is completely ineffective.

Similarily when there is a monetary expansion the LM curve shifts to right the equilibrim to reach E''. Now as the imports become expensive the Price level will increase and the LM will shift slightly to reach a point where it intersect BP and the new equilibrim F is reached where only output has increased

Part c

Holy Trinity: There remains a policy dilemma. Only 2 of the following can be acheaved while making a policy decision:

1. Free capital Mobility

2.Exchange Rate managment

3. Monetary Autonomy