5- Open Economy Macroeconomic Policy

Question 1

When is there equilibrium in the open economy?

Answer 1

When the economy is on the IS, LM and FE curve all at the same time

Question 2

What case does the Mundell-Fleming model consider?

Answer 2

Flexible exchange rates

Question 3

What are the 3 endogenous variables of the Mundell-Fleming model?

Answer 3

• Output
• Interest rate
• Exchange rate

Question 4

What effect do the 3 main curves (IS, LM, FE) have when the exchange rate is flexible?

Answer 4

• FE curve fixes the interest rate
• LM curve determines output
• IS curve determines exchange rate

Question 5

Where is the position of the economy determined in the Mundell-Fleming model?

Answer 5

The intersection between the LM and FE curves

Question 6

What is the equilibrium exchange rate?

Answer 6

The exchange rate that ensures the IS curve passes through the point where the LM and FE curves intersect

Question 7

How does the real exchange rate adjust to ensure that the IS curve passes through the LM-FE intersection?

Answer 7

• If R is less than the equilibrium exchange rate, the real exchange rate must depreciate to shift the IS curve right
• If R is greater than the equilibrium exchange rate, the real exchange rate must appreciate to shift the IS curve left

Question 8

How does fiscal policy affect the the 3 endogenous variables of the Mundell-Fleming model (Y, i, R)?

Answer 8

Fiscal policy has no affect on output and interest rate, but does affect the exchange rate

Question 9

What is the effect of a monetary policy expansion on the Mundell-Fleming model?

Answer 9

• Shifts out the LM curve to intersect the FE curve at a higher point
• The economy moves to a new equilibrium with the same interest rate but higher output
• The exchange rate depreciates; this shifts out the IS curve to intersect with the FE and new LM curve

Question 10

What is the effect of an increase in the world interest rate on the Mundell-Fleming model?

Answer 10

• FE curve shifts up
• Economy moves to a new equilibrium with increased output and interest rates
• The exchange rate depreciates: this shifts out the IS curve to intersect the LM curve and the new FE curve