Question

Imagine are the head of the Central Bank of a Republic, a large open economy with a floating exchange rate and perfect capital mobility. The government has a large budget deficit and has raised taxes to reduce the deficit. Your goal is to stabilize GDP (income) and change the money supply accordingly. Under your policy, what happens to the money supply, the interest rate, the exchange rate, and the trade balance? Explain and graph your answers using the Mundell-Fleming Model.

Answer 1

Answer:-

As per the question :-If the head of the Central Bank of a Republic has a large open economy with a floating exchange rate and perfect capital mobility. The government has a large budget deficit and has raised taxes to reduce the deficit. We will choose a perfect policy to stabilize the GDP

We will choose fiscal policy for this. Before we start we have to know what is fiscal policy.

Fiscal Policy is used by the government for government’s tax and expenditure policies in an effort to influence the behavior of the economy

Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity.AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M).

• Expansionary fiscal policy has no lasting effect on on the position of the aggregate demand curve

The Central Bank through open market operations in the foreign currency exchange market (purchase of foreign currency) increases the supply of domestic currency and prevents changes in the exchange rate

• In a small open economy, expansionary fiscal policy causes domestic interest rate to rise above world interest rate. This appreciates the RER. Thus, the Bank prevents crowding out effect on NX.
• The supply of domestic currency by the Central bank causes domestic interest rate to fall and equal world interest rate. Thus, the Bank prevents crowding out effect on investment.

The increase in money supply shifts the AD curve even farther to the right.

1-Tight Fiscal Policy

This involves decreasing AD.
Therefore the government will cut government spending (G) and/or   increase taxes. Higher taxes will reduce consumer spending (C)
Tight fiscal policy will tend to cause an improvement in the government budget deficit.

2-Loose Fiscal Policy

This involves increasing AD.
Therefore the government will increase spending (G) and cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C)
This will tend to worsen the government budget deficit, and the government will need to increase borrowing.

So the government should choose Fiscal policy to achieve that target.

Now will discuss about Mundell Fleming Model:-

Mundell-Fleming model assumes a small open economy which is incapable of influencing world interest rate. The Mundell-Fleming model — like the IS-LM model — is based on the assumption of fixed price level and shows the interaction between the goods market and the money market.

The assumption of a small open economy with perfect capital mobility plays an important role in Mundell-Fleming model. The assumption of a small open economy implies that the economy can borrow or lend as much as it likes in world financial markets without affecting rate of interest. Thus, for a small open economy, rate of interest is determined by the world interest rate.

Mathematically, we can state this assumption as:

r = rf

the basic assumption of this model is that the domestic rate of interest (r) is equal to the world rate of interest (r*) in a small open economy with perfect capital mobility. No doubt any change within the domestic economy may alter the domestic rate of interest, but the rate of interest cannot stay out of line with the world rate of interest for long..

The Mundell-Fleming model, with domestic interest rate determined by the world interest rate, focuses on the role of exchange rate in the determination of national income in the short run