Question

n the Mundell–Fleming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when taxes are raised. What would happen if exchange rates were fixed rather than floating?

Answer 1

In case of floating exchange rates.

When the taxes are raised, the IS Curve Shifts to the left. This leads to a Decrease in both the interest rate and the output in the Economy. Assuming that there is perfect capital mobility. Decrease in the Interest rate leads to an increase in net capital outflow. Increase in net capital outflow leads to the depreciation of the the domestic currency. Depreciation of the domestic currency increases Exports and decreases imports in the economy. Trade balance imporves. This leads to a rightward shift in the IS curve and IS Curve Shifts back to its original position. There is no change in Aggregate income.

Hence, in case of floating exchange rates if the taxes are raised then there is no change in aggregate income, exchange rate is increased ( where exchange rate is defined as domestic currency price of foreign currency) and Trade balance improves or Increases.

Case of FIXED EXCHANGE RATES

When the taxes are raised, IS Curve shifts to the left decreasing both the real interest rate and output ( aggregate income) initially. Decrease in the real interest rate leads to an increase in net capital outflow. this leads to an excess demand of foreign currency. The central bank then buys domestic currency and sells foreign currency in the foreign exchange market. So the money supply of the nation decreases and LM Curve shifts to the left thereby restoring the real interest rate and decreasing the aggregate income further.

Hence, in the case of fixed exchange rate when taxes are raised, there is a decrease in aggregate income, there is no change in the exchange rate and there is no change in trade balance also.