Question

6. Answer all parts (a) – (c) of this question.

1. [5 marks] Define the trade balance for an open economy and explain the relationship between the trade balance and the real exchange rate.
2. [8 marks] Consider a small open economy with perfect capital mobility. Describe the main features of the Mundell-Fleming model for such an economy and provide a graphical representation of its equilibrium.
3. [12 marks] Using diagrams to illustrate your answer analyse the effectiveness of monetary and fiscal policy in the Mundell-Fleming model.

Answer 1

Ques 6 A ) Trade Balance or the Balance of Trade is the net of Exports and Imports .

The trade balance in an open economy is determined by the

1. National Savings which is net of Income, Consumption and Government Expenditure .

2. And the net of savings and interest rates on world level.

Further, There is a relationship between the Trade Balance and Exchange Rate of the currency. It has been observed that demand and supply of goods of a certain country affects the currency by appreciating and depreciating it. With an increased demand of goods of a particular country, its exports rises thus leading to a demand for the currency of that country. An increased demand will wok favourable in determining the exchange rate for that currency.   

Ques 6 B )   The main features of Mundell-Fleming model for a small open economy with perfect capital mobility are as follows :

1. Free borrowing and lending by an economy for international markets.

2. These activities are done on an interest rate prevailing in the market and not variable under the policies established by the small economy.

3. The macro-economic adjustments are a result of the change in exchange rate.

4. The change in exchange rate domestically is done by the central bank in accordance with the prevailing economic conditions.

Model Assumptions are :

· World Interest Rate = Domestic Interest Rate

· In case of any difference, the flow of financial capital helps stabilise it.

· Small country refers to a country which has no or very less impact of the world interest rate through its activities of lending and borrowing. (which means it has less bargaining power).

The equilibrium for goods and services under this model happens at a point where LM(Liquidity-Money) and IS(Investment-Savings) Curves Intersect.

The General Equilibrium diagram under this Model is as follows :

Ques 6 B) The monetary policy will help shift the LM curve to left or right. An expansionary policy shifts it towards right and vice versa. But it is in effective in case of perfect mobility conditions but is effective in flexible exchange rate conditions.

On the other hand, fiscal policy is efficient in fixed exchange rate conditions as opposed to flexible conditions. It has an effect on the IS curve and helps it shift left or right.