Question

1. Suppose that money demand depends on consumption rather than on income, so that the equation for the money market becomes:

M/P = L [r, C(Y-T)].

Analyze the impact of a tax cut in a small open economy on the exchange rate and income under both floating and fixed exchange rates

Answer 1

Answer: Given is that the demand for money depends on consumption rather than on the on the income level of the consumers. In such a scenario, the demand for money will be directly proportional to the consumption requirement of the consumers, and any factor that would increase or decrease the availability of money in the hands of the consumers would have a great impact on the rate of exchange and the income level of the consumers. Under fixed exchanged rate, if there is a tax cut in a small open economy, this will directly result in a larger concentration of money in the hands of the consumers, i.e. the income level of the consumers increases and therefore the demand of the consumers for money would go down substantially, which will bring down the rate of exchange in the market in the longer run.

                                         However, Under the floating exchange rate system, if there is a tax cut in a small open economy, this will again directly result in a larger concentration of money in the hands of the consumers, i.e. the income level of the consumers increases and therefore the demand of the consumers for money would go down substantially, but in this case the only difference would be that the rate of exchange in the market would be volatile and flexible in the short run having a larger propensity to decrease, however, in the longer run the rate of exchange will catch up due to its floating nature and would become at par with the income level and consumption requirement of the consumers.