Question

Suppose that the price level relevant for money demand includes the price of imported goods and that the price of imported goods depends on the exchange rate.That is, the money market is described by

MP = L ( r , Y )

where P =λPd +(1−λ)1(12l)Pf/ε.

Here, Pd is the price of domestic goods, Pf is the price of foreign goods measured in the foreign currency, and ε is the exchange rate.Thus, Pf/ε is the price of foreign goods measured in the domestic currency.The parameter λ is the share of domestic goods in the price index P. Assume that the price of domestic goods Pd and the price of foreign goods measured in foreign currency Pf are sticky in the short run.

(a) Suppose that we graph the LM ∗ curve (LM curve on epsilon − Y plane) for given values of P d and P f (instead of the usual P). Is this LM∗ curve still vertical? Explain.

(b) What is the effect of expansionary fiscal policy under flexible exchange rates in this model? Explain. Contrast with the standard Mundell–Fleming model (where price level does not depend on foreign prices).

(c) Suppose that political instability increases the country risk premium and, thereby, the interest rate. What is the effect on the exchange rate, the price level, and aggregate income in this model? Contrast with the standard Mundell–Fleming model.

Answer 1

Ans:- a) :- LM bend turns out to be upward sloping not vertical this time. This is on the grounds that higher conversion standard infers that remote products become less expensive. Thus residential shoppers begin to purchase progressively outside products.

This prompts lower value P that is appropriate for the currency market. At this low value level the genuine parity M/P gets higher.

Consequently to keep currency market in equilibrium salary need to rise so as cash demand.

b) :- According to standard Mundell-Fleming model expansionary fiscal policy doesn't influence yield level under coasting swapping scale. In any case, for our situation that contention isn't right as demonstrated as follows :-

As in this case LM curve is upward sloping for any expansionary fiscal policy (tax cut) applied, IS curve shifts right. As a result output output increases from Y1 to Y2.

c) :- The Mundell-Fleming model keeps the world financing cost, r* as given exogenously for making the model an oversimplified one.

At the point when loan fee increases over the world financing cost, capital inflows happens, which acknowledges the conversion scale. With acknowledged cash, nation's fares are diminished and imports are expanded. In this manner the exchange shortage happens. This reductions the pay so it comes to back to its unique level. In this manner total pay stays unaltered.

The outcome is distinctive when the swapping scale is fixed. At the point when the administration lessens charges, arranged consumption PE bend in Keynesian cross again moves expanding the loan costs. Utilization and speculation rises and subsequently the IS movements to one side.

Since the economy has a now a fixed conversion scale framework, when the loan fee increases over the world financing cost, national bank quickly intercedes and offers the excess household money to spread out the liquidity.

With rising cash gracefully, LM, movements to one side. This move keep on happening till the fixed degree of swapping scale is resolved. With increasing cash gracefully and falling loan cost, venture demand rises and thus the total pay is expanded.

Anyway there is no adjustment in the conversion scale. Exchange balance also stays unchanged.