Question

Intermediate Macroeconomic Question.

1. Given that the money supply is 1400, consumption equation is represented as:

C = 120 + 0.7 (Y-T),

investment equation is I=200-10r, where r is the real interest rate while Taxes (T) and Government expenditure are 200 and 400 respectively. The real money demand function is expressed as m/p=0.1y -100r (units in million)

i) Solve for equilibrium real output and equilibrium interest rate

ii) Assume that autonomous investment increases by 300, compute the investment multiplier and analyze the new impact on income and consumption.

b) Use the Mundell- Fleming to show that under perfect mobility and flexible exchange rates, fiscal policy is ineffective.

c) Discuss the key assumptions of the Mundell - Fleming model.

Answer 1

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a) (i) Y= C+I+G

= 120+ 0.7 (Y-200) + 200 – 10r + 400

0.3 Y = 580 -10 r

0.1 Y =1400 +100r

By solving both the equation,

We get, Y =2322.5, r = - 0.11%

(ii) investement multiplier = 1/0.3

= 3.33

Income will increase by 3.33 * 300

= 999

Consumption will increase by 999 - 300

= 699

b. Equilibrium is rehabilitating at a more or higher income and rate of interest level. In the case of mobility of capital, the upward coercion on rates of interest gives rise to adequate inflows of capital to cause the rate of exchange to appreciate. Fiscal policy is ineffective under the flexible rates of exchange with perfect mobility of capital. The Mundell-Flemingo model is an open macro application of the standard analysis of the IS-LM curve. More precisely, it is an IS-LM curve with trade and international mobility of capital.

Three aspects of Macroeconomic are;

1. Aggregate demand (IS and LM curves, representing goods and money markets)

2. Aggregate supply (production function and labor market)

3. Balance of payments (current account and capital account)

The Mundell- flamingo model amalgamate ( 1) and (3) which is AD and B (Balance of payment) curves. It means that the model in its simplest version has no supply- side constraint.As in the most elementary Keynesian model, it implicitly assumes that capital and labor are generally underemployed so that any demand stimulus will expand real GDP (rather than cause inflation).

c. The major assumptions of the Mundell-Flemingo model are:

1. The Small size of an economy: it may be called that “smallness” of an economy has no connection to its size. A small economy denotes as which cannot change the world rate of interest through its activities of borrowing and lending. In contrast, a big economy is one that has the market power of bargaining so that it can exercise impact over the world interest rate.

2. Perfect factor mobility: the main assumption of this model is that the host country’s ROI ( r) equal to the world rate of interest (r*) in a small open country with perfect mobility of capital. No doubt any variance within the host (domestic) economy may change the domestic ROI, but the ROI cannot stay out of line with the world ROI for long. The variance between the two, if any, is neglected fast through outflows and inflows of financial capital. The Investment will flow to economies where the return is maximized.

3. Fixed money wage: resources of unemployment and constant return to scale are assumed.

4. Taxes and savings: increases with the income

5. The Domestic level of price is kept constant: and the supply of domestic output is elastic.

6. Balance of money emphasizes on demand and rate of exchange and demand for money focused or emphasized income and rate of interest.