Question

You are the chief economic adviser in a small open economy with a floating exchange rate. Your boss, the president of the country, wishes to increase the level of output in the short run in order to win the upcoming election. Do you recommend monetary or fiscal policy? Should the policy be expansionary or contractionary? Explain in detail the reasons for your proposed policy using a Mundell-Flemming model. Do not provide diagrams with the answer. (100 words maximum)

Answer 1

Mundell-Fleming & Growth of Output
According to the Mundell-Fleming model, an open small economy has nothing to do with its fiscal policies with floating exchange rates. The growth of output can be influenced by an expansionary monetary policy. Monetary expansion through reducing interest rates will depreciate the value of the domestic currency with the foreign currency. This makes the domestic goods cheaper compared to the foreign goods. The economy will be encouraged to increase the level of output and employment with the advantage of expensive foreign goods which in turn increases the return over exports. So, in an economy with floating exchange rate, monetary expansion helps in increasing the level of output and attaining better trade balances.