The Mundell-Fleming model assumes that net exports depend only on the exchange r

Question

The Mundell-Fleming model assumes that net exports depend only on the exchange rate, so we write NX = NX(e). Suppose that net exports also depend on aggregate income: Higher income means higher spending on goods and services, some of which is spent on imports. Then we have NX = NX(e,Y), where NX is negatively related to both e and Y. A. Suppose the economy operates under a floating exchange rate system. Now suppose there is an increase in government purchases. Compare the impact on the trade balance, NX, when NX = NX(e,Y), with that when NX = NX(e). B. Suppose the economy operates under a fixed exchange rate system. Now suppose there is an increase in government purchases. Compare the impact on the trade balance, NX, when NX = NX(e,Y), with that when NX = NX(e). (Note: First, refresh your memory of the impact of an increase in G on e and Y in the IS*-LM*model under both types of exchange rate systems.) The Mundell-Fleming model assumes that net exports depend only on the exchange rate, so we write NX = NX(e). Suppose that net exports also depend on aggregate income: Higher income means higher spending on goods and services, some of which is spent on imports. Then we have NX = NX(e,Y), where NX is negatively related to both e and Y. A. Suppose the economy operates under a floating exchange rate system. Now suppose there is an increase in government purchases. Compare the impact on the trade balance, NX, when NX = NX(e,Y), with that when NX = NX(e). B. Suppose the economy operates under a fixed exchange rate system. Now suppose there is an increase in government purchases. Compare the impact on the trade balance, NX, when NX = NX(e,Y), with that when NX = NX(e). (Note: First, refresh your memory of the impact of an increase in G on e and Y in the IS*-LM*model under both types of exchange rate systems.) The Mundell-Fleming model assumes that net exports depend only on the exchange rate, so we write NX = NX(e). Suppose that net exports also depend on aggregate income: Higher income means higher spending on goods and services, some of which is spent on imports. Then we have NX = NX(e,Y), where NX is negatively related to both e and Y. A. Suppose the economy operates under a floating exchange rate system. Now suppose there is an increase in government purchases. Compare the impact on the trade balance, NX, when NX = NX(e,Y), with that when NX = NX(e). B. Suppose the economy operates under a fixed exchange rate system. Now suppose there is an increase in government purchases. Compare the impact on the trade balance, NX, when NX = NX(e,Y), with that when NX = NX(e). (Note: First, refresh your memory of the impact of an increase in G on e and Y in the IS*-LM*model under both types of exchange rate systems.)

Explanation / Answer

Under the fixed rate system, an increase in government spending will shift the IS curve to the right. This will mean that the income (GDP) and interest rates both have risen. Now, an increase in interest rates will attract foreign invesotrs to the country. Foreign investors will demand domestic currency and therefore it will appreciate. An appreciation of currency increases imports as foreign goods are now cheaper for the people in the country, and this will also hit exports since domestic goods become more expensive for foreigners. Thus, the GDP will shift back to the left, and the net effect of increase in government expenditure is zero in this case.  

Thus NX = NX(e,Y) has a negative trade balance with that of NX = NX(e) since exports have gone down.

B). Increased Govt. expenditure will shift the IS curve to the right, leading to an increase in interest rate. This will lead to higher foreign investments (because of foreign investors being attracted to higher interest rate) and thus putting an upward pressure on the domestic currency. To maintain this pressure, the monetary authority will purchase foreign currency using domestic funds thereby shifting LM curve to the right. Thus, the interest rate will remain the same but the income will rise.

Thus, NX = NX(e,Y) will have no impact on trade balance as an increase in domestic exchange rates will be normalised by the government by purchasing foreign currency.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.