Answer to Question #56481 in Macroeconomics for abdirauf sheikh

Question

Using appropriate model, illustrate the effect of an expansionary fiscal policy in an open economy operating in free exchange rate regime .Assume perfect capital mobility. What is the effect if the government uses monetary policy alternatively?
a. The Balance of payment deficit is not a problem in a free exchange rate regime? Explain.
b. In a fixed exchange rate regime, monetary policy is ineffective? Is this true? Explain using the mundell- fleming model

Answer 1

Expansionary fiscal policy involves government attempts to increase aggregate demand. It will involve higher government spending and / or lower tax. In theory, higher government spending will increase aggregate demand (AD=C+I+G+X-M) and lead to higher economic growth.
Lower taxes should increase disposable income of consumers leading to higher levels of consumer spending. This should also increase aggregate demand and could lead to higher economic growth.
Expansionary fiscal policy can also lead to inflation because of the higher demand in the economy.
Expansionary monetaty policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. This is done by increasing the money supply available in the economy. Expansionary policy attempts to promote aggregate demand growth.
a. The Balance of payment deficit is a problem in a free exchange rate regime. At fixed exchange rates policy makers cannot devalue the currency in an attempt to hide inflation or a balance of payments deficit.
b. In a fixed exchange rate regime, monetary policy is ineffective, because the exchange rate is fixed there is no ability to use monetary policy to stimulate the economy.