Question

Consider the Mundell-Fleming model with flexible exchange rate for a small open economy characterised by a downward sloping IS curve and a vertical LM curve. If the risk premium of the country increases, then which one of the following options is CORRECT?

• A. income increases
• B. exchange rate appreciates
• C. domestic interest rate declines
• D. both IS and LM curve shift to the left

Hint:

In the Mundell-Fleming model with risk premium, an increase in risk premium raises domestic interest rate and can increase income through the money market adjustment.

Answer 1

The Correct Option is A

Step 1: Recall domestic interest rate relation.
In a small open economy with risk premium, domestic interest rate is
\[ r=r^*+\theta \]
where \(\theta\) is the risk premium.

Step 2: Effect of increase in risk premium.
If risk premium increases, then
\[ \theta \uparrow \Rightarrow r \uparrow \]
So, domestic interest rate increases.

Step 3: Impact on money market.
Money market equilibrium is
\[ \frac{M}{P}=L(r,Y) \]
Since money demand decreases when interest rate rises, higher \(r\) reduces money demand.

Step 4: Restore money market equilibrium.
To restore money market equilibrium with fixed real money supply, income must rise because higher income increases money demand.
Thus,
\[ Y \uparrow \]

Step 5: Analyze exchange rate effect.
Higher risk premium generally leads to depreciation, not appreciation, of the domestic currency.
Therefore, option (B) is incorrect.

Step 6: Check other options.
Domestic interest rate does not decline; it increases.
So, option (C) is incorrect.
Both IS and LM curves do not shift left.
So, option (D) is incorrect.

Step 7: Final conclusion.
Hence, income increases when the country risk premium increases.
\[ \boxed{\text{income increases}} \]
Therefore, the correct option is (A).