Question

answer the following:

d. In the Mundell-Fleming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when taxes are raised. What would happen if exchange rates were fixed rather than floating?

Answer 1

Ans- The Mundell-Fleming Model (MFM) describes the workings of a small economy open to international trade in goods and financial assets, and provides a framework for monetary and fiscal policy analysis. In sharp contrast to the expansionary fiscal policy,in mundell Fleming model expansionary monetary policy under flexible exchange rate regime is highly effective in raising the level of national income or output.

In the mundell Fleming,an increase in the tax shifts the IS curve to the left(decrease). When exchange rate floats freely, then the LM curve is unaffected. The exchange rate falls while Aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase.

Now suppose it is converted into fixed exchange rate. When IS curve shift to the left(decrease),the money supply has to fall to keep the exchange rate to be remain unchanged. As a result output will fall while the exchange rate is fixed.Net export will also remain unchanged.

So we can conclude from the above points that fiscal policy is effective at influencing output under fixed exchange rate but ineffective in floating exchange rate.