Question

The Mundell–Fleming model takes the world interest rate r∗ as an exogenous variable. Let’s consider what happens when this variable changes.

1. What might cause the world interest rate to rise? (Hint: The world is a closed economy.)

2. If the economy has a floating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises?

3. If the economy has a fixed exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises?

Answer 1

1) World interest rate would rise , when world demand for investment rises, or there is a decline in world savings.

2)The IS curve would shift to the left,when increase in the world interest rate would lower investment.This would lead to lowering of the nominal exchange rate and thus net exports would rise . But aggregate income will remain constant.

3)With the shift of the IS curve to the left, the LM curve will shift to the left in order to keep the nominal exchange rate constant.As a result output will fall but net exports will not be affected.