Question

Exercise 3 (7 points): According to Mundell-Fleming (IS-LM-BP) model, which are the consequences (i.e the new equilibrium compared with the equilibrium position before the policy) of an increase in public expenditure if exchange rates are fixed and there is capital immobility? 1 Increase in net exports, same income 21 Increase in income, reduction in net exports Incrase of income, depreciation of the exchange [3] Increase in the interest rate, decrease of income. [1 same income, same interest rate; ® Increase in the interest rate, reduction of money none of the above. 5 Increas e in money supply, same income rate; supply:

Answer 1

According to the question, there will be no change in interest rate and income (option 7).

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When capital is immobile then fixed exchange rate curve (BP) is vertical. As public expenditure increases which is a part of fiscal policy then IS curve shifts from IS1 to IS2. This situation of the deficit in the balance of payment. This depreciates the value of the currency. To correct the situation, the government will sell foreign currency and buy back the domestic currency. This will shift the LM curve from LM1 to LM2. New equilibrium shifts from E1 to E2. This, fiscal policy under fixed exchange rate with capital immobility does not affect the income and rate of interest.