Chapter # 13 Tutorial Questions & Answers

Multiple Choice Questions

1. The key difference between the IS–LM model and the Mundell–Fleming model is that the:
A. Mundell–Fleming model does not take the price level as fixed.
B. Mundell–Fleming model assumes a small open economy.
C. Mundell–Fleming model stresses the interaction between markets different from those in the IS–
LM model.
D. Mundell–Fleming model is not used to evaluate monetary and fiscal policy effects.

Answer: B
Note: The key innovation that the Mundell–Fleming model makes is to assume a small open
economy.

2. According to the Mundell–Fleming model, an appreciation of the exchange rate would:

A. decrease both import demand and export demand.
B. increase import demand and decrease export demand.
C. decrease import demand and increase export demand.
D. increase both import demand and export demand.

Answer: B
Note: The Mundell–Fleming model assumes that net export demand is a decreasing function of the
real exchange rate. Thus, as the exchange rate appreciates, import demand rises and export demand
falls.

3. If the IS* curve in the Mundell–Fleming model is expressed by the equation Y = C(Y – T) + I(r*) + G
+ NX(e) then NX(e) should be interpreted as meaning that:
A. net exports depend positively on the exchange rate.
B. exports depend negatively on the exchange rate.
C. imports depend positively on the exchange rate.
D. net exports depend negatively on the exchange rate.

Answer: D
Note: NX stands for net exports, which have a negative relationship with the real exchange rate.

4. The Mundell–Fleming model predicts that, in Y – e space, an appreciation of the exchange rate will
cause the IS* curve to:
A. shift to the left.
B. shift to the right.
C. become steeper.
D. remain unchanged.

Answer: D

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5. The Mundell–Fleming model predicts that, in Y – e space, an appreciation of the exchange rate will
cause the LM* curve to:
A. shift to the left.
B. shift to the right.
C. become steeper.
D. remain unchanged.

Answer: D
Note: The Mundell–Fleming LM* curve is not a function of the real exchange rate. Therefore, a rise in
the real exchange rate will have no effect on the LM* curve.

6. Suppose that the Mundell–Fleming model is depicted in a Y – e graph. The equilibrium would then
occur at the point where the:
A. IS* and LM* curves intersect.
B. IS* curve crosses the world interest rate.
C. LM* curve crosses the domestic interest rate.
D. LM* curve crosses the world interest rate.

Answer: A
Note: According to the Mundell–Fleming model, in Y – e space, equilibrium occurs where the IS* and
LM* curves intersect.

7. In a small open economy with a floating exchange rate, a fiscal expansion:

A. increases income.
B. decreases income.
C. leaves income unchanged.
D. could increase or decrease income, depending on what happens to the exchange rate.

Answer: C
Note: The Mundell–Fleming model predicts that a fiscal expansion will induce a rise in the real
exchange rate. This results in a fall in net export demand, which offsets the expansion. Thus, the net
effect on income is 0.

8. According to the Mundell–Fleming model, in a small country with a floating exchange rate, a tax
cut will cause the exchange rate to:
A. rise.
B. rise in the same proportion as inflation.
C. remain constant.
D. fall.

Answer: A
Note: A tax cut, which is an example of expansionary fiscal policy, would cause the IS* curve to shift
to the right. This implies a new, higher real exchange rate.

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9. In a small open economy with a floating exchange rate, a monetary expansion:
A. increases income.
B. decreases income.
C. leaves income unchanged.
D. could either decrease or increase income, depending on what happens to the exchange rate.

Answer: A
Note: The Mundell–Fleming model predicts that a monetary expansion will put downward pressure
on the real exchange rate. This results in a rise in net export demand, which produces a higher level
of income.

10. Under a system of floating exchange rates, a monetary contraction by the central bank would
cause the exchange rate to:
A. rise.
B. rise in the same proportion as inflation.
C. remain constant.
D. fall.

Answer: A
Note: According to the Mundell–Fleming model, the monetary contraction will cause the LM* curve
to shift to the left, which causes the real exchange rate to rise.

11. Suppose the European Union was a small open economy under floating exchange rates. If the EU
imposes a quota on Japanese cars in an effort to reduce the trade deficit, then:
A. the exchange rate goes up and the trade deficit goes down.
B. the exchange rate goes up and the trade deficit remains unchanged.
C. the exchange rate goes down and the trade deficit remains unchanged.
D. both the exchange rate and the trade deficit go down.

Answer: B
Note: The Mundell–Fleming model tells us that restricting imports increases net export demand and
causes the IS* curve to shift to the right. This results in a rise in the real exchange rate, which reduces
net export demand, offsetting the effect of the restriction on imports.

12. In an open economy with a fixed exchange rate, a fiscal contraction:

A. increases both the money supply and income.
B. increases the money supply and decreases income.
C. decreases the money supply and increases income.
D. decreases both the money supply and income.

Answer: D
Note: According to the Mundell–Fleming model, the fiscal contraction shifts the IS* curve to the left
and produces downward pressure on the exchange rate. To preserve the initial exchange rate, the
money supply must fall (and the LM* curve must shift to the left). Both effects serve to reduce
income.

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13. In an open economy with a fixed exchange rate, expansionary monetary policy:
A. increases income.
B. decreases income.
C. lowers the interest rate.
D. is impossible.

Answer: D
Note: According to the Mundell–Fleming model, if the central bank were to attempt to expand the
money supply, the LM* curve would shift to the right, putting downward pressure on the real
exchange rate. In order to preserve the initial exchange rate, the money supply would have to
decrease. This makes monetary policy impossible.

14. Under a system of fixed exchange rates, an import restriction on foreign goods would cause net
exports and the level of income to:
A. rise.
B. rise in the same proportion as inflation.
C. remain constant.
D. fall.

Answer: A
Note: If exchange rates are fixed, an import restriction will cause both net exports and the level of
income to rise.

15. Under a system of fixed exchange rates:

A. only monetary policy can affect income.
B. only fiscal policy can affect income.
C. both monetary and fiscal policy can affect income.
D. neither monetary nor fiscal policy can affect income.

Answer: B
Note: When exchange rates are fixed, fiscal policy is effective, but monetary policy is not.

16. Under a system of floating exchange rates:

A. only monetary policy can affect income.
B. only fiscal policy can affect income.
C. both monetary and fiscal policy can affect income.
D. neither monetary nor fiscal policy can affect income.

Answer: A
Note: When exchange rates are allowed to float, monetary policy can affect income, but fiscal policy
is ineffective.

17. Suppose country A has a higher risk premium than country B. One can then infer that country A:
A. is more productive than country B.
B. is more politically stable than country B.
C. is less politically stable than country B.
D. has more borrowers than country B.

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Answer: C
Note: The risk premium is the amount that borrowers must pay to compensate lenders for political
risk and/or expected changes in the exchange rate. Since a higher risk premium is demanded of
country A (assuming no expected changes in the exchange rate), country A must be less politically
stable than country B.

18. Many economists favor a system of floating exchange rates because it:
A. allows the government to use monetary policy as an output stabilizer.
B. forces the central bank to restrict the money supply.
C. reduces exchange rate uncertainty.
D. allows the government to use trade restrictions to control the current account balance.

Answer: A
Note: Under a system of floating exchange rates, the government can use monetary policy to
influence the level of output. Under a system of fixed exchange rates, the money supply must be
devoted to defending the exchange rate.

19. Which of the following is impossible for a country to choose simultaneously?

A. fixed exchange rate, free capital flows, and an independent monetary policy
B. flexible exchange rate, free capital flows, and an independent monetary policy
C. fixed exchange rate, capital controls, and an independent monetary policy
D. fixed exchange rate, free capital flows, and a monetary policy subject to keeping the exchange rate
unchanged

Answer: A
Note: According to the “impossible trinity,” a fixed exchange rate, free capital flows, and an
independent monetary policy cannot be simultaneously chosen by a country.

20. When a country adopts a currency board, its central bank:

A. keeps the exchange rate fixed to another currency.
B. holds enough foreign reserve to back every unit of domestic currency.
C. both keeps the exchange rate fixed to another currency AND holds enough foreign reserve to back
every unit of domestic currency.
D. increases its ability to implement monetary policy.

Answer: C
Note: A currency board fixes the value of the domestic currency to another currency and holds
foreign currency to back every domestic currency issued.

21. The aggregate demand curve is downward-sloping in a small open economy because a decline in
the price level raises real money balances and:
A. lowers the interest rate, thereby expanding investment.
B. raises wealth, thereby expanding consumer spending.
C. lowers the exchange rate, thereby expanding net exports.
D. increases the exchange rate, thereby expanding net exports.

Answer: C

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Note: A reduction in the price level will raise real balances, lower the exchange rate and expand net
exports.

22. Choose the pair of words that best completes this sentence: In a large open economy, monetary
policy is ____ potent and fiscal policy is ____ potent than in a closed economy.
A. less; more
B. less; less
C. more; more
D. more; less

Answer: D
Note: A large open economy has a flatter IS curve. This implies that monetary policy is more potent
and fiscal policy is less potent than in a closed economy.

23. A fiscal expansion in a large open economy will:

A. not increase GDP, just as in a small open economy.
B. increase GDP, just as in a small open economy.
C. increase GDP, but by a larger magnitude than in a small closed economy.
D. increase GDP, but by a smaller magnitude than in a small closed economy.

Answer: D
Note: A large open economy has a flatter IS curve. This implies that monetary policy is more potent
and fiscal policy is less potent than in a closed economy.

24. Compared to a small open economy, which of the following is more effective in a large open
economy?
A. Expansionary monetary policy is more effective in a large open economy than in a small open
economy.
B. Expansionary fiscal policy is more effective in a large open economy than in a small open economy.
C. Neither expansionary monetary policy nor expansionary fiscal policy is more effective in a large
open economy than in a small open economy.
D. Both expansionary monetary policy and expansionary fiscal policy are more effective in a large
open economy than in a small open economy.

Answer: D
Note: In a large open economy, the IS curve is flatter, making monetary policy more effective than in
a small open economy. Further, expansionary fiscal policy can increase income in a large open
economy, whereas it is not effective in a small open economy.

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Short Answers

1.In the Mundell–Fleming model with floating exchange rates, explain what happens to aggregate
income, the exchange rate, and the trade balance when taxes are raised. What would happen if
exchange rates were fixed rather than floating?

Answer:

In the Mundell–Fleming model, an increase in taxes shifts the IS* curve to the left. If the exchange
rate floats freely, then the LM* curve is unaffected. As shown in Figure 1, the exchange rate falls
while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance
to increase.

Now suppose there are fixed exchange rates. When the IS* curve shifts to the left in Figure 2, the
money supply has to fall to keep the exchange rate constant, shifting the LM* curve from LM*1 to
LM*2. As shown in the figure, output falls while the exchange rate remains fixed.

Net exports can only change if the exchange rate changes or the net exports schedule shifts. Neither
occurs here, so net exports do not change.

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We conclude that in an open economy, fiscal policy is effective at influencing output under fixed
exchange rates but ineffective under floating exchange rates.

2. In the Mundell–Fleming model with floating exchange rates, explain what happens to aggregate
income, the exchange rate, and the trade balance when the money supply is reduced. What would
happen if exchange rates were fixed rather than floating?

Answer:

In the Mundell–Fleming model with floating exchange rates, a reduction in the money supply reduces
real balances M/P, causing the LM* curve to shift to the left. As shown in Figure 3, this leads to a new
equilibrium with lower income and a higher exchange rate. The increase in the exchange rate
reduces the trade balance.

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If exchange rates are fixed, then the upward pressure on the exchange rate forces the Fed to sell
dollars and buy foreign exchange. This increases the money supply M and shifts the LM* curve back
to the right until it reaches LM*1 again, as shown in Figure 4.

In equilibrium, income, the exchange rate, and the trade balance are unchanged.

We conclude that in an open economy, monetary policy is effective at influencing output under
floating exchange rates but impossible under fixed exchange rates.

3. In the Mundell–Fleming model with floating exchange rates, explain what happens to aggregate
income, the exchange rate, and the trade balance when a quota on imported cars is removed. What
would happen if exchange rates were fixed rather than floating?

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Answer:

In the Mundell–Fleming model under floating exchange rates, removing a quota on imported cars
shifts the net exports schedule inward, as shown in Figure 5. As in the figure, for any given exchange
rate, such as e, net exports fall. This is because it now becomes possible for Americans to buy more
Toyotas, Volkswagens, and other foreign cars than they could when there was a quota.

This inward shift in the net-exports schedule causes the IS* schedule to shift inward as well, as
shown in Figure 6.

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The exchange rate falls while income remains unchanged. The trade balance is also unchanged. We
know this since

NX (e) = Y – C(Y – T) – I(r) – G

Removing the quota has no effect on Y, C, I, or G, so it also has no effect on the trade balance. The
decline in net exports caused by the removal of the quota is exactly offset by the increase in net
exports caused by the decline in the value of the exchange rate.

If there are fixed exchange rates, then the shift in the IS* curve puts downward pressure on the
exchange rate, as above. In order to keep the exchange rate fixed, the Fed is forced to buy dollars
and sell foreign exchange. This shifts the LM* curve to the left, as shown in Figure 7.

In equilibrium, income is lower and the exchange rate is unchanged. The trade balance falls; we know
this because net exports are lower at any level of the exchange rate.

4. What are the advantages of floating exchange rates and fixed exchange rates?

Answer:

The following table lists some of the advantages and disadvantages of floating versus fixed exchange
rates.

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5. Describe the impossible trinity. Illustrate by using a diagram.

Answer:

The impossible trinity states that it is impossible for a nation to have free capital flows, a fixed
exchange rate, and independent monetary policy. In other words, you can only have two of the
three. If you want free capital flows and an independent monetary policy, then you cannot also peg
the exchange rate. If you want a fixed exchange rate and free capital flows, then you cannot have
independent monetary policy. If you want to have independent monetary policy and a fixed
exchange rate, then you need to restrict capital flows.

Note: A nation cannot have free capital flows, independent monetary policy, and a fixed exchange
rate simultaneously.
A nation must choose one side of this triangle and give up the opposite corner.

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