Question

7. Consider an economy that abides by a Mundell Fleming model. Suppose there is an expansionary fiscal shock. Assume that capital is perfectly immobile, short run prices are perfectly sticky, and exchange rates are floating. Moreover, assume that the domestic and foreign interest rates were equal prior to the shock. Which of the following is true? Note: This is a non-standard case and may not reach a typical short-run equilibrium.

A. The increase in interest rates will compel the supply of FX to expand (shift right).

B. The increase in domestic income will weaken the dollar, causing the IS curve to shift outward.

C. The increase in domestic interest rates will compel the domestic currency to weaken, causing NX to rise, and the IS curve to shift right.

D. The BoP surplus that results from the expansionary shock will lead to capital outflows, thereby weakening the domestic currency.

Answer 1

Answer B. The increase in domestic income will weaken the dollar, causing the IS curve to shift outward.

Reason- Since Capital is immobile, BoP will be vertical and interest rate will be irrelevant.

When there is expansionary fiscal policy, it leads to rightward shift in IS curve as income increases. When income increses imports increases leadig to rising demand for foreign exchange. Dollar will weaken which will lead to rising export. Net export increases and IS curve further shifts outwards.