Question

a.) Explain, in words and on a graph, how a fiscal stimulus works in a Mundell-Fleming model with a fixed exchange rate. Is this effective fiscal stimulus policy?

b.) Explain, in words and on a graph, how a fiscal stimulus works in a Mundell-Fleming model with a floating exchange rate. Is this effective fiscal stimulus policy?

Answer 1

a) Fiscal policy is extremely effective under fixed exchange rate system. If there is fiscal expansion then IS curve shifts rightwards which causes increase in interest rate. Higher interest rate results into capital inflow and thereby surplus in Balance of Payment. Due to this there is pressure for currency appreciation. But to keep exchange rate fixed central bank will intervene by selling home money and receiving foreign money. This causes monetary expansion and LM curve shifts rightward. With rightward shift of LM curve interest rate returns back to initial level but the significant point is that with fiscal expansion output of economy has increase which indicates effectiveness of fiscal policy.

b) Under flexible exchange rate system, central bank will not intervene in foreign exchange market in order to influence exchange rate. The exchange rate must adjust so that demand and supply of foreign exchange becomes equal. Adjustment in exchange rate ensures that the sum of current account balance and capital account balance is zero.

Another implication of flexible exchange rate is that central bank can set money supply because there is no obligation to intervene. So, there is no longer any automatic link between Balance of Payment and Money supply. In flexible exchange rate system, Fiscal policy is ineffective because effect of fiscal expansion is crowded out by change in Net Exports.

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Due to fiscal expansion in the form of increase in government expenditure, IS curve shifts rightward but with rightward shift of IS curve interest rate increases which results in inflow of capital and surplus in Balance of Payment. Due to this domestic currency appreciates and it causes decline in net exports. Therefore, there is no change in output an interest rate.