Question

In the Mundell-Flemming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when the money supply is increased. Contrast what would happen if exchange rates were fixed rather than floating? (10marks)

Answer 1

Mundell-Flemming model - Effect of money supply increase

Flexible exchange rates:

The LM curve shifts to the right with the increase in money supply. Consequently, local interest rates reduces vis-a-vis global interest rates. This leads to increased capital outflows (hit to BoP) which in turn leads to fall in real exchange rates. Subsequently, the IS curve shifts right until local and global interest rates equalise.

Thus. there is an increase in aggregate income or output due to expansionary monetary policy under this regime.

Fixed exchange rates:

In case of BoP surplus, money flows into the country raising the money supply (vice versa in case of BoP deficit). The Central Bank then through the sterilication process absorb newly arrived money by selling local bonds (vice versa in case of moeny outflow from the country).

Under this regime, expansionary monetary policy does not result in raising aggregate income or output.