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GATE 2023 Question 55: Open-economy macroeconomics

Consider a Mundell-Fleming model for a small open economy with perfect capital mobility. The goods market equation is

$Y = C(Y) + I(r^*) + G + NX(e)$

where $Y$ is the output, $C$ is the consumption ( $C'>0$ ), $I$ is the investment ( $I'<0$ ), $G$ is the government purchases, and $NX$ is the net exports ( $NX'<0$ ), $r^*$ is the fixed world interest rate, and $e$ is the exchange rate.

The money market equation is

$\frac{M}{\bar P} = kY - lr^*$

where $M$ is the money supply, $\bar P$ is the fixed price level, and $k$ and $l$ are positive constants.

Which of the following policies is/are ineffective (i.e., have no impact on income) in the short-run?

Select all that apply.

Answer and worked solution

Answer: (A) and (D)

This tests the standard Mundell-Fleming policy-effectiveness results under perfect capital mobility (a small open economy where $r=r^*$ always holds):

Under a floating exchange rate: the money market equation directly pins down $Y$ (since $r=r^*$ is fixed by capital mobility, and $M,\bar P$ are policy/exogenous, $Y$ is fully determined by the LM equation alone). This means:

Fiscal policy (A) shifts IS, but since $Y$ is already pinned by LM, the shift only changes $e$ (via crowding out through the exchange rate/net exports), not $Y$ — fiscal policy is ineffective. (A) correct (is ineffective).
Monetary policy (B) shifts the LM curve itself (changes $M$ ), which directly changes the pinned-down $Y$ — monetary policy is effective under floating rates. (B) incorrect (it is NOT ineffective — it works).

Under a fixed exchange rate: the central bank must adjust $M$ to defend the fixed $e$ , meaning $M$ becomes endogenous, and it's the IS curve (via $G$ ) that effectively determines $Y$ . This means:

Fiscal policy (C) shifts IS and — since the central bank must accommodate by adjusting $M$ to hold $e$ fixed — this raises $Y$ : fiscal policy is effective under fixed rates. (C) incorrect (it is NOT ineffective).
Monetary policy (D): an attempt to expand $M$ under a fixed exchange rate is undone almost immediately, since defending the peg requires the central bank to reverse any independent money-supply change — monetary policy is ineffective under fixed rates. (D) correct (is ineffective).

Therefore the policies that are ineffective are (A) and (D).

The trap: A;C

This is the classic 'fiscal vs monetary policy effectiveness' Mundell-Fleming result, and it's easy to misremember the pairing — students sometimes recall 'one policy works, one doesn't, under each regime' correctly in spirit but swap which specific policy is ineffective under which specific regime, e.g. mistakenly pairing fiscal-ineffective with fixed rates instead of floating rates.

Plain-text version

Consider a Mundell-Fleming model for a small open economy with perfect capital mobility. The goods market equation is Y = C(Y) + I(r*) + G + NX(e) where Y is the output, C is the consumption (C′>0), I is the investment (I′<0), G is the government purchases, and NX is the net exports (NX′<0), r* is the fixed world interest rate, and e is the exchange rate. The money market equation is M/P̄ = kY - lr* where M is the money supply, P̄ is the fixed price level, and k and l are positive constants. Which of the following policies is/are ineffective (i.e., have no impact on income) in the short-run? (A) Expansionary fiscal policy under floating exchange rate (B) Expansionary monetary policy under floating exchange rate (C) Expansionary fiscal policy under fixed exchange rate (D) Expansionary monetary policy under fixed exchange rate

Also written as: Consider a Mundell-Fleming model for a small open economy with perfect capital mobility. The goods market equation is Y = C(Y) + I(r*) + G + NX(e) where Y is the output, C is the consumption (C'>0), I is the investment (I'<0), G is the government purchases, and NX is the net exports (NX'<0), r* is the fixed world interest rate, and e is the exchange rate. The money market equation is M/P_bar = kY - lr* where M is the money supply, P_bar is the fixed price level, and k and l are positive constants. Which of the following policies is/are ineffective (i.e., have no impact on income) in the short-run?

Open-economy macroeconomics has come up 55 times in 7 exams since 2006.

What this question tests

This question is on The Mundell-Fleming model: IS, LM and BP, part of Open-economy macroeconomics in International Economics.

The open-economy extension of IS-LM with a balance-of-payments schedule.

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