Question

Q.3 The Mundell-Fleming model takes the world interest rate r* as an exogenous variable. Let's consider what happens when this variable changes. a. What might cause the world interest rate to rise? b. In the Mundell-Fleming model with a floating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises? In the Mundell Eleming model with fived exchange rate what happens to aggregate

Answer 1

Solution nything which decreases world Savings or which increases world investment demands caves the world interest rate to raise would saving and world investment demand is brought into equilibrium by world real interest rate in an open economy in the long run the mundell - fleming model takes the world interest rate, t as an en externally - Orginating variable while we can't expect the world interest rate to be constant I Also, the world interest rate rises whenever world wide demound for goods increases or world wide Supply of money - decreases ecreases LMT EMA you abnoypx BLIST Y112 income output

Fig: Effect of an increase in the wild interest rate under firuling exchange rates Is* curve shifts left as investment I[v+] faus LM* curve shifts right as money demand decreases . The higher interest rate leads to an excess supply of real balances as suppley of real balances (M/P) is fixed. . To restore equilibrium in money market , income must sise, this increases the demand for money till there is no longer an excess for supply Thus, whenever the world interest rate will rise, capital outflow increases as the interest rate in the small country audjusts to the new higher level of the world interest rate. The increase in capital -out How causes the exchange rate to fall, causing net exports and hence, output to increase, which increases money demand Thus, as we can see from the figure output rises, exchange rate falles and the trade balance increases 13

од овару Income output Figo- Effect of an increase in the world interest rate if exchange rates are fixed.. Both the Ist and LN* Carver shift Ist shift to the left. LM* shift to the left as downward pressure on the exchange rates causes Central bank to buy dollars and sell foreign exchange. This reduces the supply of money and causes LM * to shift to the left In equilibrium output falls while he exchange rate remains uncharged. Thus, trade balance also remains unchanged