The Mundell-Fleming model takes the world interest rate r as an exogenous variab
ID: 1195466 • Letter: T
Question
The Mundell-Fleming model takes the world interest rate r as an exogenous variable. Let's consider what happens when this variable changes.
(a) What might cause the world interest rate to rise?
(b) In the Mundell-Fleming model with a floating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance in a small open economy when the world interest rate rises?
(c) In the Mundell-Fleming model with a fixed exchange rate, what happens to aggregate income, the exchange rate, and the trade balance in a small open economy when the world interest rate rises?
Explanation / Answer
a) Fall in the money supply and demand for investment cause world interest rate to rise.
b) When world interest rates rises, then investment falls. Domestic money moves towards the profitable destination and exchange rate falls. Export will become competitive. Overall income shall remain constant.
c) Again investment fall, here money supply decreases due to interference of central bank. or LM curve shifts to left. Here now export shall remain unaffected but output decreases.