Question

In: Economics

3. The government of a small open economy with floating exchange rate system wants to establish...

3. The government of a small open economy with floating exchange rate system wants to establish a stronger currency.

  1. Suggest both an appropriate monetary policy adjustment and an appropriate fiscal policy adjustment that would allow the economy to move to a higher exchange rate. Explain your answer using Mundell-Fleming model for each policies.                                                                                (3)

  1. What are the consequences of these adjustments on domestic output and net exports? (2)

Solutions

Expert Solution

3.

The Mundel Fleming Model is used analyze the impact of various fiscal and monetary policies in both fixed and flexible exchange rate systems. The model explains how changes in macroeconomic policy tools influence the exchange rates and its effects on the economy’s income and net exports.

Below are the following assumptions in order to proceed:

· Economy is small and open

· Flexible Exchange Rate System is followed

· There is Perfect Capital Mobility: Costless movement of capital from one country to another that makes the BP curve perfectly elastic (horizontal).

· Points above the BP curve shows Balance of Payment surplus, whereas point below BP curve shows Balance of Payments Deficit

· Current output level is equal to the potential level of output, which means Internal Balance is maintained. Here both goods and money market are in equilibrium.

· The sum of the current and the capital account is zero, which means the balance of payments is balanced and thus External Balance is maintained.

Equilibrium under this model is given by the point where all the below three curves intersects:

1. Downward Sloping - Investment Savings (IS)

2. Upward Sloping - Liquidity Monetary Preference (LM)

3. Horizontal Balance of Payment curve

At this point both internal as well as external balance is maintained. Along with this the domestic interest rates are equal to the world interest rates (i=i*)

Refer to the diagrams below: In both the panels (Panel A and B) X-axis shows the output level and Y-axis shows the interest rates. Initial equilibrium is maintained at Point A where both internal and external balance is maintained. Here equilibrium level of income is Y1 and equilibrium interest rates are i=i*. In order to establish a stronger currency, the government might use an Expansionary Fiscal or a Contractionary Monetary policy. The impact of both the policies on Exchange Rate and the consequences of these adjustments on Income and Net Exports are explained in detail individually:

o Expansionary Fiscal Policy (Panel A)

- An Expansionary fiscal policy in the form of either an increased government spending or a reduction in tax rate, shifts the IS curve rightwards from IS1 to IS2.

- The economic equilibrium moves up from Point A to Point B. Here output/income rises from Y1 to Y2 & domestic interest rate increases to i2.

- Since, domestic interest rates are greater than the foreign interest rates (i2 > i*), domestic deposits become more attractive that result into huge capital inflows. At this point, there is a balance of payment surplus in the economy.

- There is an increase in demand for domestic currency that leads to an increase in exchange rates which means there is an exchange rate appreciation.

- As a consequence of a much stronger currency than before, the price of domestically produced goods and services rises that makes domestic exports less competitive in the market. As a result Export supply falls and import demand increases, which makes the Net Exports to fall.

- With a reduction in net exports, the IS curve shifts back downwards from IS2 to IS1 pushing the output and the domestic interest rates back to their initial levels of Y1 and “i" respectively.

- Hence, a fiscal expansion under Mundel Fleming model with perfect capital mobility causes the exchange rate to increase, that results in the fall of Net exports but an unchanged level of income/output.

o Contractionary Monetary Policy (Panel B)

- A Contractionary Monetary policy such as an increase in the interest rate or a fall in the required reserve ratio causes the real money supply in the economy to fall. This shifts the LM curve upwards from LM1 to LM2.

- Here economic equilibrium moves up from Point A to point B, where output falls from Y1 to Y2 and domestic interest rate rises to i2.

- Since, domestic interest rates are greater than the foreign interest rates (i2 >i*), domestic deposits become more attractive that result into huge capital inflows. At this point, there is a balance of payment surplus in the economy.

- There is an increase in demand for domestic currency that leads to an increase in exchange rates which means there is an exchange rate appreciation.

- As a consequence of a much stronger currency than before, the price of domestically produced goods and services rises that makes domestic exports less competitive in the market. As a result Export supply falls and import demand increases, which makes the Net Exports to fall.

- With a fall in net exports, the IS curve shifts downwards from IS1 to IS2, that pushes back the domestic interest rate equal to its original level and output falls even further to Y3. The economic equilibrium shifts to point C.

- Hence, a monetary contraction under Mundel Fleming model with perfect capital mobility causes the exchange rate to increase, that results in the fall of Net exports as well as a fall in the income and output levels.


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