Answer to Question #286744 in Macroeconomics for Shek Ahmed

Question

In the Mundell-Flemming Model, under the floating exchange rate regime, if money supply increase, what will happen to output and exchange rate? Briefly explain.

Answer 1

Fiscal policy

Stimulating fiscal policy leads to upward pressure on the domestic interest rate. Capital rushes from abroad to the country, the exchange rate is rising, net exports are falling. Since the equilibrium value of income does not change when applying this policy, its short-term and long-term consequences are the same.

Monetary policy

An increase in the supply of money leads to an increase in real cash reserves, which causes an increase in the equilibrium value of income in the money market (at a constant interest rate).An increase in the money supply exerts downward pressure on the interest rate, leading to capital outflow abroad, a fall in the real exchange rate, and consequently, an increase in net exports and income. Thus, in the short term, a stimulating monetary policy leads to an increase in income.