Assume that we analyze the Mundell-Flaming model and that the government of big open economy decides...

Assume that we analyze the Mundell-Flaming model and that the government of big open economy decides to increase its public spending. How will it influence:

domestic income, interest rate, and exchange rate, given that we face perfect capital mobility under flexible exchange rate regime?

Expert Solution

Under flexible exchange rate regime, fiscal policy is not successful in raising the level of output and employment in economy.

It can be illustrated with help of diagram:

Increase in government spending pushes up IS curve to right thereby leading to higher level of exchange rate. or domestic currency appreciates. Appreciation of domestic currency hampers export of country.

There is no rise in output level or income.

Exchange rate increases due to inflow of new foreign exchange.

Government spending drives up interest rate.

Rahul Sunny answered 2 years ago

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