Mundell-Fleming Model Use the Mundell-Fleming Model to predict what happens to a
ID: 1167640 • Letter: M
Question
Mundell-Fleming Model
Use the Mundell-Fleming Model to predict what happens to aggregate income y, the exchange rate e, and the trade balance NX, under both floating and fixed exchange rates in response to each of the following shocks:
a.A fall in consumer confidence about the future induces consumers to spend less and save more.
b.The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars.
The introduction of automatic teller machines reduces the demand for money.
Explanation / Answer
Answers: a) Mundell-Fleming model with flexible exchange rates with a decrease in autonomous residential investment.
The reduction in autonomous investment shifts the IS curve inward. The reduction in autonomous investment reduces income at the original exchange rate and decreases the demand for real money balances, placing downward pressure on r and causing a rise in net capital outflow. This increases the net supply of domestic currency on the foreign exchange markets, decreasing the exchange rate to E2. The lower exchange rates make exports less expensive abroad and imports more expensive domestically, hence NX rises exactly enough to offset the drop in autonomous investment. Output returns to Y1
Mundell-Fleming model with fixed exchange rates with a decrease in autonomous residential investment.
Similar to the flexible exchange rate case, the reduction in autonomous consumption shifts the IS curve inward, put downward pressure on r and the exchange rate. In order to prevent E from falling, the central bank must buy domestic currency by selling foreign currency. This decreases the foreign reserves and money supply, shifting the LM curve inward. Output falls to Y2. Since the exchange rate does not change, net exports do not change either.
b) Uncertainties in the securities market raises the demand for real money balances at any given r and Y. Since real money supply stays fixed and the domestic interest rate is fixed at the world interest rate level, this creates an excess demand of real money balances. To restore equilibrium in the money market, income must fall in order to reduce the demand for money. That is, the LM* curve shifts to the left. Intuitively, the increase in money demand will put upward pressure on r, causing a net capital inflow and an appreciation of the domestic currency. This will reduce net exports and output.
With a fixed exchange rate regime, the LM* curve shifts to the left as before. This put upward pressure on r and E. The central bank therefore must sell domestic currency and buy foreign currency to keep the exchange rate from rising. This increases foreign reserve and money supply, shifting the LM* curve back to the right. Both output and net exports remain unchanged
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