Question

Please explain using Mundell-Flemming model and Foreign exchange Market Model. Show graphs. Please answer part b and c.

3. (16 marks total) Consider the Mundell-Fleming short-run small open economy model, with ri.e., no risk premium), and r given exogenously (a) (5 marks) Suppose foreign governments undertake a fiscal expansion, which raises the world interest rate Assuming the domestic central bank is operating a flexible ex- change rate, use an IS'-LM' diagram to show what happens to output and the exchange rate. What happens to the trade balance? Does the country experience a net capital outflow, inflow, or no change in its net capital position? b) (6 marks) Answer the same questions as in part (a), but assuming the central bank is operating a fixed exchange rate. (c) (5 marks) In your answer to part (b), what happens to the domestic money stock? What happens to the central bank's foreign exchange reserves? Under what conditions would the central bank have no choice but to abandon its fixed exchange rate? Would this ever be a problem under the reverse situation, i.e., if foreign governments had instead undertaken a fiscal contraction which lowered r*7

Answer 1

(b) The initial equilibrium is at point E where the IS-LM curve intersects the Balance of payment(BoP), and the world interest rate is i. Now, the foreign governments undertake a fiscal expansion and increase the world interest rate. The BoP line shifts upward and capital flows to take advantage of the opportunity. Pressure on Home currency to depreciate, which makes the central bank sell its foreign reserves. The decrease in the money supply due to this outflow causes the LM curve to shift left until it intersects the IS-BoP line. The new equilibrium is at point E' and the interest rate is i^*.

LM 1S レ B0f Bof 0

(c) The domestic money stock increases.

The central bank's foreign exchange reserve decreases

The central bank will abandon the fixed exchange rate when it has exhausted the foreign reserves and its ability to borrow.

If the government would have taken fiscal contraction policy and lowered the word interest rate, the opposite occurs. The BoP shifts downward and capital inflows into the home country The inflow causes the LM curve to shift right and domestic interest rate becomes lower.