Question

Short answer: Answer each of the questions in Section B. Answers should typically be no more than 2-3 sentences in length.

1. In the Mundell-Fleming model, what are the two endogenous variables that appear in the goods-market equilibrium condition (after substituting in all relevant functions, e.g., C = C(Y ? T), etc.)? How does this compare to the case in the (closed economy) IS-LM model? Be sure to explain the reason for any differences

2. Briefly describe how “debt deflation” works; that is, how this mechanism might cause an unexpected fall in the price level to produce a large fall in output (e.g., in the Great Depression).

3. Consider the IS-LM model, and suppose G increases by ?G units. In general equilibrium, does output increase by more, less, or the same amount as µG × ?G (where µG is the government spending multiplier)? Be sure to explain why this is the answer.

Answer 1

Answer:

1) After substituting in all relevant functions GDP and the domestic interest rate are two endogenous variables that appear in the goods market equilibrium condition. In the closed economy model, if the central bank expands the money supply then the LM curve shifts out and as a result income goes up and the doemstic interest rate goes down, but in the Mundell-Fleming model open economy model with perfect capital mobility, monetary policy becomes ineffective.

2) Debt deflation occurs due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. The fall in price level causes by the fall in aggregate demand resulting from the rise in real rate of interest which urges borrowers to reduce their demand for loan, this reaction makes credit and thus depoits currency to fall. The inevitable result is that demand for goods fall and prices falls furthermore.

3) If we assume that prices remain constant and the existing level of aggregate output i.e. Real National Income is below the full employment levell. In this situation there is a scope for increase in outout or real national income and therefore when the government expands its expenditure causing increase in aggregate demand, firms increase their outpput annd employment. In such case magnitude of fiscal multiplier is quite large.