Question

?Mundell-Fleming ?Suppose that the price level relevant for money demand includes the price of imported goods, which in turn depends on the exchange rate. That is, the money market is described by where M/P =L(r,Y), P = ?Pd + (1 ? ?)Pf/ e

Here, Pd is the price of domestic goods in domestic currency and Pf is the price of foreign goods in foreign currency. Thus, Pf/e is the price of foreign goods in domestic currency. The parameter ? ? (0, 1] is the share of domestic goods in the price index P . Assume the Pd and Pf are sticky in the short-run.

(a) (2 points) Graph the LM ? curve on Y ? e plane.

(b) (2 points) What is the effect of expansionary fiscal policy under floating exchange rates in this model? How is it different from the benchmark Mundell-Fleming model discussed in class?

(c) (2 points) Suppose that political instability increases the country risk premium ? so that r = r? + ?. What is the effect on the equilibrium exchange rate and aggregate income in this model? How is it different from the benchmark Mundell-Fleming model discussed in class?

Answer 1

The Mundell-Fleming model exhibits the determination of equilibrium exchange rate and output level in an open economy, with the interaction of IS-LM network

a) LM curve is graphed below. Here the effect of a contractionary fiscal policy is analysed.

b) For simple working of the model, assume that taxes are reduced. When the government reduces taxes, planned expenditure PE curve in Keynesian cross shifts upwards, raising the interest rates. Consumption and investment rises and thus the IS shifts to the right. Income rises in the initial stage as a result of rise in consumption and investment.

Since the economy has a flexible exchange rate system, when interest rate rises above the world interest rate, capital inflows occurs, which appreciates the exchange rate. With appreciated currency, country’s exports are decreased and imports are increased. Therefore the trade deficit occurs. This decreases the income so that it reaches back to its original level. Therefore aggregate income remains unchanged.

The result is different when the exchange rate is fixed. When the government reduces taxes, planned expenditure PE curve in Keynesian cross again shifts increasing the interest rates. Consumption and investment rises and thus the IS shifts to the right.

Since the economy has a now a fixed exchange rate system, as soon as the interest rate rises above the world interest rate, central bank immediately intervenes and sells the surplus domestic currency to spread out the liquidity.

With rising money supply, LM, shifts to the right. This shift continue to occur till the fixed level of exchange rate is determined. With rising money supply and falling interest rate, investment demand rises and hence the aggregate income is increased. However there is no change in the exchange rate. Trade balance too remains unchanged.

c) The Mundell-Fleming model keeps the world interest rate, r* as given exogenously for making the model a simplistic one.

When interest rate rises above the world interest rate, capital inflows occurs, which appreciates the exchange rate. With appreciated currency, country’s exports are decreased and imports are increased. Therefore the trade deficit occurs. This decreases the income so that it reaches back to its original level. Therefore aggregate income remains unchanged.

The result is different when the exchange rate is fixed. When the government reduces taxes, planned expenditure PE curve in Keynesian cross again shifts increasing the interest rates. Consumption and investment rises and thus the IS shifts to the right.

Since the economy has a now a fixed exchange rate system, as soon as the interest rate rises above the world interest rate, central bank immediately intervenes and sells the surplus domestic currency to spread out the liquidity.

With rising money supply, LM, shifts to the right. This shift continue to occur till the fixed level of exchange rate is determined. With rising money supply and falling interest rate, investment demand rises and hence the aggregate income is increased. However there is no change in the exchange rate. Trade balance too remains unchanged.