Question

Draw and analyse contractionary fiscal policy under a floating exchange rate of the mundell fleming model. Give your explanation, reasonings and your conclusion

Answer 1

In the given diagram, the contractionary fiscal policy shifts the IS curve left, from IS to IS'. This shift would result in an intermediate equilibrium at point e1 from the initial equilibrium point e.

At e1, the goods market and money market will be in equilibrium, but the domestic interest rate would be lower to the interest rate in the rest of the world. There will be the flight of the capital away from the domestic economy and the balance of payments deficit would occur at the new equilibrium point e1.

Since the exchange rate is free to adjust to eliminate the balance of payments deficit under the floating exchange rate regime, the intersection of the IS and LM curves cannot remain below the BP curve. The capital flight would result in the depreciation of the domestic currency.

This will increase the domestic exports and decrease imports. As net exports rise, the IS curve shifts right from IS' back to IS.

When the IS curve has returned to the initial equilibrium position that passes through point e, equilibrium is restored in all markets.

Note that the final equilibrium occurs at the initial level of i and Y.

With floating exchange rates, fiscal policy is ineffective in shifting the level of income.

When a contractionary fiscal policy has no effect on income, complete crowding out has occurred. This crowding-out effect occurs because the currency depreciation induced by the contractionary fiscal policy increases net exports to a level that just offsets the fiscal policy effects on income.