Question

Answer the following questions for Small Open Economy in the short run with floating exchange rates (SOE in the SR)

a) In the Mundell–Fleming model (SOE in the SR) with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when taxes are decreased. (8 points)

b) In the Mundell–Fleming model (SOE in the SR) with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when the money supply is reduced. (8 points)

c) In the Mundell–Fleming model (SOE in the SR) with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when a tariff on imported goods is imposed. (9 points)

Answer 1

For all the questions we assume a perfect capital mobility situation.

Answer to the question no. a:

A reduction in taxes increases the disposable income. This will increase the level of consumption. This will shift the IS curve to the right. Given the LM curve a shift in the IS curve will raise the domestic rate of interest and thus the domestic rate of interest will go above the foreign rate of interest. This will lead to a inflow of foreign capital in the domestic economy. In turn, this raises the demand for domestic currency and thus the domestic currency will appreciate and the foreign currency will depriciate (exchang rate fall). A fall in the exchange rate will raises the import over export and the net export falls. Fall in the net export will shift the IS curve again to the left and thus the equilibrium rate of interest (world interest rate=domestic interest rate) restored. Thus the output and rate of interest will not rise due to a fall in the taxes. Thus, under floating exchange rate, the fiscal policy is ineffective.

Answer to the question no. c:

A reduction in money supply will lead to a fall in the interest rate (domestic). This will cause the outflow of foreign capital from the domestic economy. In turn, this raises the demand for foreign currency and thus the domestic currency will depriciate and the foreign currency will appreciate (exchang rate rises). A rise in the exchange rate will raises the export over import and the net export rises. An increase in net export will cause the IS curve to shift rightward. This shift will continue untill the world rate of interest is becomes equal to the domestic interest rate. Then eventually the equilibrium rate of interest (world interest rate=domestic interest rate) restored and the output (income) will rises. Thus, under floating exchange rate, the monetary policy is effective.

Answer to the question no. a:

An imposition of tariff on the imported good will reduce the import and caues the net export to go up. This will shift the IS curve to the right. Given the LM curve a shift in the IS curve will raise the domestic rate of interest and thus the domestic rate of interest will go above the foreign rate of interest. This will lead to a inflow of foreign capital in the domestic economy. In turn, this raises the demand for domestic currency and thus the domestic currency will appreciate and the foreign currency will depriciate (exchang rate fall). A fall in the exchange rate will raise the import over export and the net export falls. Fall in the net export will shift the IS curve again to the left and thus the equilibrium rate of interest (world interest rate=domestic interest rate) restored. Thus the output and rate of interest will not rise due to a fall in the taxes. Thus, under floating exchange rate, the fiscal policy is ineffective.

Hope, I solved your query. Give good feedbak.

Comment, I'll get back to you ASAP.

Stay safe. Thank you.