A small economy stays at full employment. The authorities decide to change the structure of demand...
A small economy stays at full employment. The authorities decide to change the structure of demand in order to increase investment. What should be the mix of fiscal and monetary policy if there is no international mobility of capital and the economy has fixed exchange rates? Show your results drawing the necessary diagram. (Mundell-Fleming model)
Homework Answers
The moment we talk about increasing investment spending, we need to think of a policy mix that reduces the interest rate.
A policy mix would be an expansionary fiscal policy and a monetary expansion.
A fiscal expansion, in the form of an increase in government spending, or decreased taxes, shifts the IS curve rightward from IS1 to IS2. If a monetary expansion is simultaneously adopted, this would shift the LM curve rightward from LM1 to LM2. The output increases from Y1 to Y2. And the interest rate falls from i1 to i2. This fall in interest rate will boost investments (as we know, investment is inversely related to interest rate).
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