Final: Mundell Fleming Model

Question 1

The MF model shows the interaction between what?

Answer 1

The MF model shows interaction between the goods market and the money market

Behavior of economies on the international stage depends heavily on the choice of exchange rate regime (fixed or floating)

Question 2

Assumptions of MF model

Answer 2

Fixed price level: The price level at home and globally do not vary much. Thus,P = P*. The model is assumed for the analysis of short-run fluctuations.

Exchange rates are nominal: Forward = future spot rates

Unemployed resources take a constant value

Constant returns to scale

Analysis centers on a Small Open Economy (SOE): Actions do not affect world interest rates, Capital is infinitely mobile (sigma=infinity)

Question 3

IS(Investment Savings EQ)=

Answer 3

IS (Investment Savings EQ)= C+I+G+NX
C= Consumption (+)
I = Investment (+)
G= Government Spending (+)
NX= Net exports = (exports-imports) (+)

Question 4

LM (Liquidity Preference/Money Demand)=

Answer 4

LM (Liquidity Preference/Money Demand)= M/P= L(i,Y)
M= Money Supply (+)
P = Price Level (-)
L= Real money demand as a function of interest rates and output
I (-)
Y(+)

Question 5

BOP Curve:

Answer 5

BOP= CA+FA
FA= σ(i-i)
Where σ is capital openness, (i) is the domestic interest rate, and (i) is the foreign interest rate.
(i-i) is the UIRP built into the model.
CA= NX
BOP= NX + σ(i-i) = 0

Question 6

Fixed exchange rate

Answer 6

Fixed: partial control of inflation, currency attacks, less day-to-day exchange rate uncertainty, “excessive” disturbances

Question 7

Floating exchange rate

Answer 7

Floating: control of monetary policy, currency attacks less likely, more day to-day uncertainty, immunization from foreign shocks

Question 8

Fixed Exchange Rates
and the CB

Answer 8

The central bank loses arbitrary control over the money supply, and instead adjusts the MS upward or downward to maintain the exchange rate at a predetermined level.
CB stands ready to buy or sell domestic/foreign currency to maintain the fixed exchange rate

In the MF model, this occurs through movements in the LM curve

Question 9

When does IS shift right?

Answer 9

When there is an expansionary fiscal policy change or the exchange rate depreciates (i.e., e increases)

Question 10

When does IS curve shift left?

Answer 10

When there is a contractionary fiscal policy change or when the exchange rate appreciates

Question 11

When does LM curve shift right?

Answer 11

when there is an expansionary monetary policy change?

Question 12

When does LM curve shift left?

Answer 12

when there is a contractionary monetary policy change

Question 13

When does the BP shift?

Answer 13

Fixed. The BP does not shift, regardless of the degree

Question 14

SOE, PCM: Expansionary Monetary Policy Under Fixed ER

Answer 14

1. ΔM>0
2. LM curve shifts out
3. Domestic interest rates lower than world interest rates
4. Capital outflows
5. Exchange rate begins to depreciate
6. Central bank must contract MS before exchange rate depreciates
7. LM curve shifts back to initial position
   Conclusion: Monetary policy has no effect under fixed exchange rates

Question 15

SOE, PCM: Expansionary Monetary Policy Under Floating ER

Answer 15

1.ΔM>0
2.LM curve shifts out
3.Domestic interest rates lower than global interest rates
4.Capital outflows (UIRP)
5.Exchange rate depreciates
6.Net exports increase
7.IS shifts out
Conclusion: Expansionary monetary policy has a positive effect on output under floating exchange rates

Question 16

SOE, PCM: Expansionary Fiscal Policy Under Fixed ER

Answer 16

1.ΔG>0
2.IS shifts out
3.Domestic interest rates higher than world interest rates
4.Capital inflows
5.Exchange rate begins to appreciate
6.Central bank must supply more domestic currency to stop the appreciation
7.LM curve shifts out
Conclusion: Expansionary fiscal policy has a positive effect on output under fixed exchange rates

Question 17

MF and Import Restrictions (Tariffs/Quotas)

Answer 17

Import restrictions won’t reduce the trade deficit

Fewer imports appreciate the domestic currency
In turn, this reduces exports

NX remains unchanged

However, less overall trade, fewer gains from trade

Import restrictions protect some industries but destroy jobs in exporting industries.
Employment/Output unaffected

Question 18

Problems the MF model

Answer 18

Only fit to analyze short runs shocks, or effects of policies in the short-run
Short-run = fixed price level

Ad-hoc Model
Simply postulated. No micro foundations.

Overemphasizes the effect of fiscal/monetary policy on output