Question

The Mundell-Fleming model take the world interest rate i* as an exogenous variable. What happens when this variable changes. Which causes might drive the world interest rate up?

Assume that the world interest rate rises. What happens in the foreign exchange market and the money market, under a fixed exchange rate? Show graphically effects to aggregate income, the exchange rate, and the trade balance, and give a brief explanation.

How do authorities control the trade balance under a fixed exchange rate?

Answer 1

If the world interest rate changes then it will impact the country's saving and investment and finally its net capital inflow. A rise in i will increase saving, decrease investment and reduce net import of capital while a fall in i will increase investment, decrease saving and increase net capital inflow (true for a small economy). In the long run economy, the world interest rate is determined where world saving and investment equilibriates. Any factor which may increase world investment demand or decrease world savings will cause i to rise. While in the short run when prices are rigid, any factor which may increase world's aggregate demand or reduce world's aggregate supply will increase the world interest rate.

As world interest rate rises, this attracts investor to invest in the home currency. This means higher i increases demand for home currency and hence would drive exchange rate higher. As world interst rates are higher, investments would crowd out at home and hence Investment falls, and so the IS curve will shift leftwards. The impact on LM curve will be that it shifts to the left. Since exchange rate is fixed. There will be downward pressure on exchange rate and to maintain the fixed level of exchange rate, central bank will have to buy home currency and sell foriegn currency. This means there will be a decrease in the domestic money supply. Thus LM shifts leftwards.

In the figure drawn, IS shifts left from from IS1 to IS2 while LM curve shifts leftwards from LM1 to LM2. Note that due to the fixed exchange rate, the LM curve must shifts leftwards to the point where the fixed exhange rate line cuts IS2. Thus in equilibrium aggregate income falls from Y1 to Y2. Since exchange rate is fixed it does not change and hence there is no impact of exports and imports meaning trade balance is unaffected.

The authorities will buy and sell its own currency to maintain the fixed exchange rate. For e.g. if domestic currency appreciates, central banks will sell their home currency reserves so as to reduce the value of the currency by increase the supply in the forex market. This way the authorities maintain the exchange rate and hence maintain the trade balance.