Question

Q2. Mundell-Fleming model.

Consider an open economy IS-LM model. China's currency is the “Chinese Yuan Renminbi (CNY)" and the USA's currency is the “US dollar (USD)". China has a fixed exchange rate regime with respect to USD. The central bank of China maintains a peg of 1 CNY=0.14 USD. The interest rate in the USA is 2.5%.

a. What do the above facts imply about the interest rate in China? Explain.

b. Suppose that the USA experiences an increase in output ??∗. With the help of a diagram explain the short-run effects of the increase in ??∗ on the economy of China. What happens to output and net exports? Carefully label your diagram.  

c. Suppose the USA Federal Reserve Bank conducts an expansionary monetary policy and lowers its interest rate to 2%. How will the central bank of China react if it wants to maintain the exchange rate peg? What will be the effect of this on the interest rate in China?

d. Following part (c), with the help of a diagram explain the short-run effects of the foreign expansionary monetary policy on the economy of China. What happens to output and net exports?

e. Suppose instead that China decides to abandon the fixed exchange rate regime and to adopt a flexible exchange rate regime. With the help of a diagram explain how your answers in part (b) would change? What would happen to output, net exports, and nominal exchange rate?  

Answer 1

(a). The above given fact that there is fixed exchange rate in China, the interest rates in both the countries will be equal.

i_U = i_C = 2.5%

(b). If USA experiences increase in output then, then demand for chinese goods and services increases in USA and this leads to increase in net exports (NX) of China. With increase in NX, the IS curve of China shifts to right , thus creating a balance of payment surplus. Since , there is fixed exchange rate regime, the central bank of China will increase the money supply, shifting the LM curve to the right to LM₁. This will increase the output to Y₁, as shown in diagram below.

(c). When USA lowers its interest rate to 2%, then i_C > i_U, this leads to capital inflows in China. And thus demand for CNY increases. But central bank of china wants to keep the exchange rate fixed, therefore, it increases the supply of currency to match the excess demand, as shown in figure below. This leads to lower interest rate in China due to 2 reasons:

1. with fixed exchange rate, the interest rate has to be equal .

2. with increased money supply, interest falls.

(d). The foreign expansionary monetary policy lead to increase of money supply in China and fall in interest as discussed in part (c). This shifts the LM curve to LM₁, which increases the chinese output. With increased output, chinese demand for imports rises and NX falls. This shifts the IS curve to IS₁ which brings back the output level to its original, as shown below.

(e). If China decides to adopt flexible exchange rate regime, then with increase in output of USA, NX of china increases, thus shifting the IS curve to IS₁. Now there is balance of payment surplus. With flexible exchange rate, CNY appreciates and hence chinese imports rise and NX falls. With this, IS curve shifts back to its original position and output also remains the same.