Question

In the Mundell–Fleming model with floating exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when the money supply is reduced. What would happen if exchange rates were fixed rather than floating?

Answer 1

Answer: In the Mundell–Fleming model, an increase in taxes shifts the IS* curve to the left. If the exchange rate floats freely, then the LM* curve is unaffected. The exchange rate falls while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase. Now suppose there are fixed exchange rates. When the IS* curve shifts to the left in the figure below, the money supply has to fall to keep the exchange rate constant, shifting the LM* curve from LM*1 to LM*2. Output falls while the exchange rate remains fixed. Net exports can only change if the exchange rate changes or the net exports schedule shifts. Neither occurs here, so net exports do not change. We conclude that in an open economy, fiscal policy is effective at influencing output under fixed exchange rates but ineffective under floating exchange rates.