Question

In the Mundell-Flemming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance if a quota on imported cars is implemented. Examine what would happen if exchange rates were fixed rather than floating? (10marks)

Answer 1

When import quota is implemented, there are restrictions on quantity of imports coming in. This causes imports to fall and exports to rise relatively. So in Y= C+I+G+ NX equation , NX rises initially. In Keynesian cross, Y(output) shifts upward putting pressure on interest rates to rise. This causes exchange rate to rise ( as in open economy, capital flows in to fetch highèr returns) and eventually exchange rate rises( appreciates). This eventually reduces exports such that the net change in NX due to restrictions is 0. Also eventually net change in income is 0.

With fixed exchange rate, Y ( income rises) due to rise in NX (i.e. difference between exports and imports widens). This puts pressure on domestic currency to appreciate, but due to fixed exchange rate, Central Bank intervenes and buys dollars. Domestic money supply rises, interest rates fall and both investment and income rise.