Question

1. Using the Mundell-Fleming model, describe the effects of:

(a)     A fiscal expansion under fixed and flexible exchange rate regimes    

(30 per cent of marks)

(b)     A monetary expansion under fixed and flexible exchange rate regimes

                                                                                         (30 per cent of marks)

(c)    An increase in the world interest rate under fixed and flexible exchange rate regimes                                                          (40 per cent of marks)

Answer 1

1. Some of the effects of fiscal expansion under fixed Exchange rate system:

• With government expenditure increases there is a shift of IS curve towards right.
• It increases both the interest rate and level of national income.
• Capital inflow in the economy is witnessed.
• The exchange rate of national currency shows a substantial increase due to capital inflows

Effects of fiscal expansion under flexible Exchange rate system:

• It leads to increase in aggregate demand which results in shift of IS curve towards right.
• It invites capital inflows in the economy resulting in appreciation in exchange rate.
• Resulting in decrease of net exports due to high interest rate.
• Impact of fiscal expansion on national income is nullify by reduction in net exports.

2. Some of the effect of monetary expansion under fixed exchange rate system:

• The monetary expansion leads the LM curve shifts to right with a new equilibrium position where domestic rate decreases
• Initially Domestic interest rate is equal to foreign interest rate any disequilibrium in it will compel the central bank to intervene
• The economy now faces deficit in balance of payments.

Effects of monetary expansion under flexible exchange rate system:

• It is highly effecting in appreciating national income
• There is a depreciation in exchange rate of domestic currency
• Rate of interest fall below the world interest rate which result in capital outflow.