Question

Problem 3 (4 points) a) Assume that a country is characterised by a small capital mobility and a flexible exchange rate. The government has increased fiscal transfers. Show the new short run equilibrium, referring to the Mundell-Fleming model. What will happen with exchange rate? Answer using appropriate graphs. (1,5p) b) Assume now that the country has "big but not perfect" capital mobility. Repeat a (start from equilibrium). Under which case -"a" or "b" will fiscal policy be more expansionary? Why? (2,5p)

Answer 1

Question :

Answer : and BP

Part A : Initial equlibrium is at E

With increase in fiscal transfer, IS shifts rightwards to IS' , IS intersects LM at E' and BP at F.

It is a situation of BOP deficit, capital outflows, then demand of foreign currency increases due to which supply of home currency increases.

This leads to depreciation of home currency, leading to increase in net exports.

Increase in net exports has two simultaneous effect:

i - IS' shifts rightwards to IS" and intersects LM at F'

ii - BP shifts rightwards till F' to BP'.

Therefore, fiscal policy is effective.

Rial h DP BP BP LM ISh IS

Part B :

Initial equilibrium is at E, with fiscal transfers IS shifts rightwards to IS' and intersects LM at E'

.BOP surplus situation, leads to capital inflow, which increases demand for home currency.

This led to appreciation of home currency due to which net exports decreases and led to :

i - IS' shifts back to IS₂ and BP shifts leftwards to BP', leading final equilibrium at E".

Therefore, fiscal policy is more effective in small country than large country.

11 LM BP BP F 4s