Question

1. 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.

b.What are the consequences of these adjustments on domestic output and net exports?

Answer 1

The Mundell Fleming Model analyzes the effectiveness of various macroeconomic policies under different exchange rate regimes that influence income and net exports in an open economy. Under this model equilibrium is given by the point where all the three curve i.e. IS, LM and Balance of Payment curve intersect. It is a point where both internal as well as external balance are maintained.

External Balance: Here the balance of payments is balanced. At any point above the BP curve, there is a balance of payment surplus due to huge capital inflows. At any point, below the BP curve there is balance of payment deficit due to huge capital outflows.

Internal Balance: Here both the goods market and the money market are in equilibrium, with current output level produced being equal to its full potential level.

Considering the case under perfect capital mobility where BP curve is horizontal and domestic interest rates are equal to the world interest rate (i = i*) we analyze the impact of Expansionary Fiscal and Contractionary Monetary policies on Exchange Rate , Output and Net Exports:

Expansionary Fiscal Policy

a. Refer to (Panel a): X-axis shows the output level and Y-axis shows the interest rates. At Point A both internal and external equilibrium is maintained. An Expansionary fiscal policy either by an increased government spending or a reduction in tax rate, shifts the IS curve rightwards from IS1 to IS2. The equilibrium moves up to point B, where output rises from Y1 to Y2 and domestic interest rate rises to i2. Since, domestic interest rates are higher than the world interest rates (i2 >i*), this makes domestic deposits (assets) more attractive that result into increased capital inflows. There is a balance of payment surplus in the economy. The demand for domestic currency rises leading to an increase in exchange rates i.e exchange rate appreciation.

b. Consequence: With a stronger currency than before, the domestic exports become less competitive in the market (home goods and service become expensive). This leads to a fall in exports and rise in imports, that causes the Net Exports to fall. With a fall in net exports, the IS curve shifts back downwards to IS1 pushing the output and the domestic interest rates to their initial levels (Y1 and i respectively). Hence, with an increased exchange rate due to a fiscal expansion, Net export falls and output level remains unchanged.

Contractionary Monetary Policy

a. Refer to (Panel b): X-axis shows the output level and Y-axis shows the interest rates. At Point A both internal and external equilibrium is maintained. A Contractionary Monetary policy such as an increase in the interest rate causes the real money supply to fall. This shifts the LM curve upwards from LM1 to LM2. The equilibrium moves up to point B, where output falls from Y1 to Y2 and domestic interest rate rises to i2. Since, domestic interest rates are higher than the world interest rates (i2 >i*), this makes the domestic deposits (assets) more attractive that result into increased capital inflows. There is a balance of payment surplus in the economy. The demand for domestic currency rises leading to an increase in exchange rates i.e. exchange rate appreciation.

b. Consequence: With a stronger currency than before, the domestic exports become less competitive in the market (home goods and service become expensive). This leads to a fall in exports and rise in imports that causes the Net Exports to fall. With a fall in net exports, the IS curve shifts downwards 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, with an increased exchange rate due to a monetary contraction, Net export as well as the output level falls.