Question

In the Mundell-Fleming model with fixed exchange rates, attempts by the central bank to decrease the money supply:

Question 21 a)

	Lead to a lower equilibrium level of income
	Lead to a higher equilibrium level of income
	Must be abandoned in order to maintain the fixed exchange rate
	Must be offset by expansionary fiscal policy
	None of the above

In the Mundell-Fleming model, in a small open economy with a fixed exchange rate, if the government increases government purchases, then in the new equilibrium:

b)

	The exchange rate rises but income does not rise.
	Income rises but the exchange rate does not rise
	Both income and the exchange rate rise
	Neither income nor the exchange rate rises, as the money supply contracts
	None of the above

The financial policy trilemma says that

c)

	An economy can maintain floating exchange rates, free capital mobility, and an independent monetary authority at the same time.
	An economy can maintain fixed exchange rates, free capital mobility, and an independent monetary authority at the same time.
	An economy can maintain floating exchange rates, low capital mobility, and an independent monetary authority at the same time.
	An economy cannot maintain fixed exchange rates, low capital mobility, and an independent monetary authority at the same time
	(a) and (c)

Answer 1

a) Answer ) Must be abandoned in order to maintain the fixed exchange rate

Under a fixed exchange rate regime with capital mobility , monetary policy is ineffective. With a monetary contraction , interest rates would rise leading to capital inflow which appreciates exchange rate. To maintain exchange rate money supply has to be increased.

b) Income rises but the exchange rate does not rise

When there is a fiscal expansion , it leads to increase in income and with this an increase in interest rates, ihher interest rates lead to appreaciaton in exchange rate. To stabilise this rise in exchange rate , there has to be a monetary expansion to decrease interest rate and bring back exchange rate to fixed level.

c) Answer )An economy can maintain floating exchange rates, free capital mobility, and an independent monetary authority at the same time

Thirs option is also correct with low capital mobility.

According to financial trillemma , a fixed exchange rate regime , a free mobility of capital and independent monetary policy cannot exist at the same time. But free mobility and independent monetary policy can be maintained with floating rate.