If a country has flexible exchange rate regime with perfect capital mobility, then according to the Mundell-Fleming Model, an expansionary fiscal policy will lead to
Select all that apply.
2 marksInternational EconomicsOpen-economy macroeconomicsPolicy under floating exchange ratesHardabout 3 min
GATE 2021 Question 29: Open-economy macroeconomics
Answer and worked solution
Answer: (A) and (B) and (C)
This is the standard Mundell-Fleming result for fiscal policy under a floating exchange rate with perfect capital mobility:
Expansionary fiscal policy (higher or lower ) initially shifts the IS curve rightward, putting upward pressure on the domestic interest rate. With perfect capital mobility, this attracts capital inflows, which appreciate the nominal exchange rate (C is correct).
The appreciation makes domestic exports more expensive and imports cheaper, which reduces net exports (B is correct) — this is the international 'crowding out' channel operating through the trade balance rather than domestic interest rates.
Because the reduction in net exports exactly offsets the initial fiscal stimulus (the LM curve is unaffected, and equilibrium income is pinned down by the money market given the world interest rate), the net result is no change in output (A is correct) — fiscal policy is entirely ineffective at raising output under these conditions.
(D), claiming output expands, is therefore incorrect — this is exactly the opposite of the Mundell-Fleming fiscal-ineffectiveness result under floating rates.
Therefore the correct statements are (A), (B), and (C).
The trap: C;D
Students sometimes recall that fiscal expansion 'should' raise output in general (as it does in a closed economy or under fixed exchange rates) and select (D) without registering that the SPECIFIC combination of floating rates plus perfect capital mobility is exactly the case where this intuition reverses — this is one of the most commonly tested 'exception' results in open-economy macro.
Open-economy macroeconomics has come up 55 times in 7 exams since 2006.
What this question tests
This question is on Policy under floating exchange rates, part of Open-economy macroeconomics in International Economics.
What monetary and fiscal policy can do when the exchange rate moves freely.
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Question from the GATE 2021 paper. Solutions are TestStop's own. Not affiliated with or endorsed by any examination authority.