Chapter 13 - The Mundell-Fleming Model & the Exchange-Rate Regime

Question 1

Give 2 reasons why r may differ from r*

Answer 1

1. Country risk (risk that lender faces political/economic turmoil. Lender may not be able to pay back loan)
2. Expected exchange rate changes (if exchange rate is expected to fall, its borrowers must pay a higher interest rate to ensure the lender gets at least as much money as they lent)

Question 2

Why is the LM* curve vertical?

Answer 2

Given r*, there is only 1 value of Y that equates money supply and money demand regardless of e.

Question 3

Why is the IS* downward sloping?

Answer 3

Decrease in e is proportional to an increase in NX.
An increase in NX is proportional to an increase in Y.

Question 4

What is the key assumption of the Mundell-Fleming Model?

Answer 4

Small open economy with perfect capital mobility

Question 5

Fixed Exchange Rate

Answer 5

Central bank stands ready to buy or sell domestic currency for foreign currency at a predetermined rate.

Question 6

Floating Exchange Rate

Answer 6

The exchange rate is allowed to fluctuate in response to changing economic conditions.