According to the Mundell-Fleming Model, in a small open economy with perfect capital mobility, when fiscal policy is used to increase government spending under a floating exchange rate regime, what is the likely short-run outcome?A.A. Exchange rate appreciates and net exports decrease.B.B. Exchange rate depreciates and net exports increase.C.C. Exchange rate remains constant and net exports remain unchanged.D.D. Interest rates fall leading to a surge in capital inflows.
Question
According to the Mundell-Fleming Model, in a small open economy with perfect capital mobility, when fiscal policy is used to increase government spending under a floating exchange rate regime, what is the likely short-run outcome?A.A. Exchange rate appreciates and net exports decrease.B.B. Exchange rate depreciates and net exports increase.C.C. Exchange rate remains constant and net exports remain unchanged.D.D. Interest rates fall leading to a surge in capital inflows.
Solution
The Mundell-Fleming Model, which is an extension of the IS-LM Model to an open economy, suggests that under a floating exchange rate system, an increase in government spending (expansionary fiscal policy) will lead to an increase in interest rates. This is due to the increase in income and thus demand for money.
With perfect capital mobility, the higher interest rates will attract foreign investors who will need to buy the domestic currency to invest. This increases the demand for the domestic currency, leading to an appreciation of the exchange rate.
As the domestic currency appreciates, domestic goods become more expensive for foreigners, leading to a decrease in net exports.
So, the likely short-run outcome is: A. Exchange rate appreciates and net exports decrease.
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