Using the Mundell-Fleming Model, explain how a monetary tightening would affect income and the nominal exchange...

Using the Mundell-Fleming Model, explain how a monetary tightening would affect income and the nominal exchange rate under floating exchange rates.

Expert Solution

initially, the economy is in equilibrium at A in IS-LM analysis. shown as above.

Now a monetary tightening implies a reduction in the money supply

=> the LM curve will shift to the LM' and the economy will move to B.

=> as a result, the interest rate will increase from i0 to i1

=> from the interest parity condition as above, the domestic interest rate will rise and hence the curve will shift to the right

=> As a result, the exchange rate will decrease which means appreciation of the domestic currency.

=> we also know that current account (X - M) + capital account (KI - KO) = 0 and since the domestic interest rate has increased more foreign investor wants to invest in the domestic country.

=> capital inflow (KI) will increase which means a capital account surplus. Hence to make BOP = 0, we need to have current account deficit and since there is an appreciation of the domestic currency which means that the price of exports is higher than the price of the imports. hence imports will increase.

=> As a result, aggregate expenditure reduces

=> now the IS curve will shift leftward till the BOP = 0 & the economy will move to C.

=> interest rate back to the initial position of i0 but now output has been decreased from Y0 to Y1.

Rahul Sunny answered 2 years ago

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