Question

Consider the two scenarios for a small open economy based on the Mundell-Fleming IS-LM model with floating exchange rate and perfect capital mobility.

Where \( Y \) is aggregate income, \( C \) is aggregate consumption, \( I \) is investment, \( r^* \) is the world interest rate, \( G \) is government expenditure, \( T \) is taxes, \( NX \) is net exports, \( e \) is exchange rate, \( M \) is money supply, and \( P^* \) is general price level. Given the relationships:
\( I \) has a negative relationship with \( r^* \),
\( NX \) depends negatively on both \( e \) and \( Y \),
\( P^* \) is fixed.
Which of the following statements is/are CORRECT?

• A. Increase in \( G \) has no effect on income in Scenario I.
• B. Decrease in \( T \) lowers income in Scenario II.
• C. Expansionary fiscal policy raises income in Scenario I and Scenario II.
• D. Expansionary fiscal policy raises exchange rate in Scenario I and Scenario II.

Hint:

Expansionary fiscal policy typically leads to an increase in income in both scenarios. Additionally, it may cause an appreciation of the exchange rate due to higher interest rates.

Answer 1

The Correct Option is A, B, D

Step 1: Analyzing the effects of changes in \( G \) in Scenario I.
In Scenario I, the aggregate income equation is:
\[ Y = C(Y - T) + I(r^*) + G + NX(e, Y) \]
An increase in government expenditure (\( G \)) leads to a direct increase in income (\( Y \)) through the expenditure multiplier. However, in Scenario I, the increase in \( G \) has a more complex effect due to the dependence of \( NX \) on both \( e \) and \( Y \), and the fact that net exports could adjust to changes in income. Since \( G \) affects income, the statement in option (A) is incorrect, as the increase in \( G \) does, in fact, affect income. So, option (A) is incorrect.
Step 2: Analyzing the effects of changes in \( T \) in Scenario II.
In Scenario II, the income equation is:
\[ Y = C(Y - T) + I(r^*) + G + NX(e) \]
Here, \( NX(e) \) is not dependent on \( Y \), so a reduction in taxes \( T \) directly raises disposable income and consumption \( C \), which results in an increase in aggregate demand and income. Therefore, the correct conclusion is that a decrease in \( T \) raises income, making option (B) correct.
Step 3: Expansionary fiscal policy in both scenarios.
Expansionary fiscal policy generally refers to an increase in government spending \( G \) or a reduction in taxes \( T \). In both Scenario I and Scenario II, an expansionary fiscal policy will lead to an increase in income as it raises aggregate demand. Therefore, option (C) is correct.
Step 4: Effects of expansionary fiscal policy on the exchange rate.
In both Scenario I and Scenario II, expansionary fiscal policy will raise aggregate income, which could lead to an increase in the interest rate. This increase in the interest rate will, in turn, lead to an appreciation of the exchange rate. Thus, option (D) is also correct.