Question

Use the Mundell-Fleming model and diagrams to predict what would
happen to aggregate income, the exchange rate, and the trade balance under both floating and fixed
exchange rates in response to each of the following policies in a small open economy.
a. Government cuts taxes.
b. Central Bank increases money supply.

Answer 1

We use the mundell fleming model to see how the given policy change affects the income,exchange rate and trade balance.

we will use IS-LM-BP curves in each case, where BP represents Balance of Payments curve which is equal to 0 in equlibrium.The vertical axis denotes the domestic interest rate and the horizontal axis denote domestic income.

• Fixed Exchange Rate : under fixed exchange rate, monetary policy is ineffective and fiscal policy is effective.

1.) Government cuts taxes : a cut in taxes leads to a rightward shift of the IS curve. It intersects the LM curve at which the rate of interest R' is greater than R* . as interest rate rises,capital inflow kicks in .currency starts to appreciate. To keep the exchange rate fixed,the central bank increases the money supply and the new equilibrium is reached at E' where income has increased and exchange rate is back to its fixed value.

2.) Increase in money supply : as money supply increases, LM curve shifts down to the right. intersects IS curve where interest rate is R' < R*. capital outflow starts. To keep the exchange rate fixed, central bank decreases the money supply. Therefore policy is reversed. Therefore exchange rate remains fixed and income remains the same.The policy reversal happens so fast so that trade balance remains unchanged.

• Flexible exchange rate : under flexible exchange rate, monetary policy is most effective.

1.) Government cuts taxes : again,due to tax cuts, IS curve shifts to the right. It intersects the LM curve where interest rate is R'' > R*. As interest rate rises above world interest rate, capital inflow starts but now there is no pressure on central bank to keep rate fixed. So currency appreciates. due to currency appreciation imports increase and exports decrease.Therefore BP curve shifts up. As Trade balance deteriorates, IS curve shifts left. New equilibrium is reached at E'' where interest rate and income is higher than initial equilibrium. There tax cuts has lead to currency appreciation, increased income and worsened trade balance.

2.) central bank increases money supply : due to increase in money supply, LM curve shifts down to the right. it intersects the IS curve where R' < R*. Therefore currency depreciates. As currency depreciates,exports increase and import decreases leading to a rightward shift in IS curve. New equilibrium is reached at E' where domestic income is greater than the initial equilibrium.Currency has depreciated and trade balance improved.