MI 2 and 3: Mundell-Flemming Model

Question 1

MF assumptions

Answer 1

• small open economy
• perfect capital mobility
• r = r*

Question 2

if r > r*

Answer 2

capital inflows increases, r decreases, demand for USD increases

Question 3

if r < r*

Answer 3

capital outflows increase, r increases, supply of USD increases

Question 4

IS* curve (Y= )
explanation of slope
(start with decrease in e)

Answer 4

Y = C(Y-T) + I(r*) + G + NX(e)
slopes downward because:
exchange rate decreases
NX drops
PE shifts down
income decreases

Question 5

LM* curve

Answer 5

(M/P)s = L(r*, Y)

Question 6

e

Answer 6

amount of foreign currency / unit domestic currency

Question 7

Floating e, fiscal policy (small open)

Answer 7

• ineffective because income does not change
• If G increases (or T decreases): is curve shifts left, e increases, income doesn’t change
  A-B (assume fixed e): if G increases, Y increases
  B-C (float e): if Y increases, L(r,Y) increases, upward pressure on r, capital inflows increase, demand for USD increases, e increases
• if e increases, NX decreases, PE decreases, Y decreases back to original level

Question 8

Floating e, monetary policy (small open)

Answer 8

• if M increases: LM curve shifts out
• e decreases, NX increases, Y increases
  A-B: if Ms increases, (M/P)s increases, downward pressure on r, capital outflows increase, supply of USD increases, e decreases
  if e decreases, NX increases, PE increases, Y increases

Question 9

Floating e trade policy

Answer 9

If import quota of tarrif:

• similar to expansionary fiscal policy
• NX curve shifts right, IS curve shifts right
• e increases, NX goes back to original level

Question 10

Fixed e, fiscal policy (small open)

Answer 10

• consider G increase
• IS* curve shifts out, Y increases, e doesn’t change
  A- B (assume floating): if G increases, upward pressure on r, increased capital inflows, increased demand for USD, e increases, NX decreases
  B - C (fix e): if e increases, central bank sells USD w/ printed money, Money supply increases, LM* shift s out, Y increases, e returns to ebar

Question 11

Fixed e, monetary policy (small open)

Answer 11

• consider Ms increases
• ineffective
• LM* shifts out, e doesn’t change, Y doesn’t change, LM* shifts back
  A - B: if Ms increases, (M/P)s increases, downward pressure on r, capital outflows increase supply of USD increases, e decreases
  if e decreases, central bank buys USD w/ federal reserves, e returns to ebar

Question 12

Fixed e trade policy

Answer 12

If import quota or tarrif:

• IS* shifts right
• LM* shifts right
• Y increases, NX does not increase