Question

According to the Mundell-Fleming model, in a small open economy with flexible exchange rates, when the world interest rate falls, the domestic interest rate in the small open economy will __________.
a. eventually fall.
b. remain unchanged.
c. rise.
d. cannot be determined.

Answer 1

The small open economy will witness the eventually falling of domestic interest.

Explanation:

Mundell-Fleming model explains the situation of the small open economy. The model has certain assumptions in which the chance of investment opportunities depends upon the rate of income and interest. In the small open economy, the size of the market is small in size when it is compared with a large open economy.

The constant output determines the effect of market forces like policies of the Government, Global market speculation of supply, and the demand for economic factors. The supply of money is stabilized only with the purchasing power of the people. This can be achieved only by the availability of cheaper interest rates against the fluctuating real exchange rate.