Question

Again consider the Mundell-Fleming model with floating exchange rate. Explain the effect of the following policy on equilibrium income and exchange rate. (Utilize Graphs and explain steps)

Policy: In an effort to improve budget, the government announces a cut on income tax of 5 billion dollars.

Answer 1

When the government announces a cut on income tax of 5 billion dollars, IS shifts rightwards as aggregate expenditure is increased with increased disposable income.

This shift from A to B does not raise the level of GDP. In the loanable funds market government will finance the tax cut which will raise interest rate.We have a flexible exchange rate system, so when interest rate rises relatively capital inflows occurs, that appreciates the exchange rate. Therefore the trade deficit occurs. This deficit decreases the income so that it reaches back to its original level.