Question

1. Analyze the effect of the following independent shocks on domestic Y and i in the Fleming-Mundell model.

a. The domestic economy experiences a fall in wages. The exchange rate is fixed and capital is imperfectly mobile. State the effect on domestic central bank reserves of foreign currency.

b. Domestic money demand falls. The exchange rate is floating and capital is perfectly mobile.

c. Foreign commercial banks decide to hold a higher fraction of each deposit on reserve. The exchange rate is fixed and capital is perfectly mobile.

d. The foreign government lowers its spending. The exchange rate is fixed and capital is perfectly mobile.

e. Suppose the domestic economy is initially above Yn. With a diagram determine whether a fixed or floating exchange rate is superior for the shock in (d). Also state your finding in a sentence.

f. Domestic firms believe domestic consumption spending will fall. The exchange rate is floating and capital is imperfectly mobile. State the final effect on domestic investment.

Answer 1

1.a. When domestic eonomy has a fall in nominal wages, it means people in the economy are earning less and so will consumer and investment less. This causes IS curve to shift from IS0 to IS1. Since capital is implerfectly mobile BP curve is upward sloping. Now due to fall in IS curve, interest rate will fall and there will be outflow of capital which can lead to currency depreciation (a downward pressure). To keep exchange rate fixed, the central bank will decrease money supply and raise interest rates to nullify the increase in i. In this process on keeping exhange rate dixed, the Cb will use open market mechanism to buy foreign exchange and increase supply of home currency and hence increase exchange rate. However since capital is imperfectly mobile, the impact gets partially nullified and the interest rate still falls but by a lower margin. Output falls substantially from Y0 to Y1, i falls from i0 to i1.

b. When domestic money demand falls, then LM curve shifts inwards from LM0 to LM1. BP is horizontal since capital is perfecly mobile. The increase in interest rates, increases capital inflow , BoP improves and currency apprecites. Currency appreciation causes imports to become cheaper and exports expensive (to foreign) and so IS curve shifts inwards from IS0 to IS1. This cause output to fall from Y0 to Y1, interest rate is unchanged.

c. The foreign money supply falls and so output falls in foreign. This leads to a fall in import demand - meaning a decrease in home country's export. (Foreign countries interest rate will not change, assuming they have perfect capital mobility and fixed exchange rate). This will cause inward shift in IS curve from IS0 to IS1. This should decrease interest rate, however to keep exchange rate fixed, the CB will decrease money supply to increase interest rates. LM curve shifts to the left. This causes output to fall but interest rates remain unchanged.

d. When the foreign government reduces its spending, Its means there output has fallen. Interest rate will again not change given foriegn has perfect capital mobility and fixed exchange rate. As there output has fallen, they will reduce imports and so home country's exports fall. IS curve shifts left which can interest rate and hence exchange rate to fall. However to keep exchange rate pegged, CB will decrease money supply and keep interest rates unchanged. Output falls.