Question

Examine the effects of a decrease in foreign output and foreign interest rate under flexible exchange rate regime when the goal of the central bank is to achieve output stability (Hint: Use Mundell - Fleming model). What happens to the components of demand?

draw the relevant graph

Answer 1

The Mundell-Fleming Model is the international trade and finance into macroeconomic theory. This approach was developed by canadian economist J. Marcus Fleming in 1960.

The model shows that, under the flexible exchange rate regime, fiscal policy does not have any potential to affect output. The monetary policy is very effective in the model and tends to decrease the interest rate, and also encourages an outflow of financial capital as domestic investors wants higher returns by buying foreign bonds.

This model is also known as IS-LM-BP model.

1. IS = Investment Saving Curve.

2. LM = Liquidity preference money supply.

3. BP = Balance of payments curve

BP = Current account + Capital Account.

Effects :-

1. Increase in government spending,

2. IS curve is shifted to right side.

3. BP curve schedule flatter than LM.

4. Cut down of exports and exchange rate will fall and BP curve shifts to left.

DIagram

Component of demand are four,

1. Consumption.

2. Investment.

3. Government Spending.

4. Net exports

Because of a decrease output and foreign output and foreign interest rate under flexible exchange rate regime all these four demand components are decreased.