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: Set the Mundell Fleming scene.
A small open economy with a flexible exchange rate, a downward sloping IS curve and a vertical LM curve, with perfect capital mobility.

Step 2: Find what anchors output.
With a vertical LM curve, output is pinned by the money market alone. Under a flexible rate, fiscal policy cannot move output, because any push is offset through the exchange rate.

Step 3: Trace a fiscal expansion.
More government spending tends to raise the interest rate, which pulls in foreign capital. That inflow makes the domestic currency appreciate.

Step 4: See the offset.
The stronger currency hurts net exports, which falls back exactly enough to cancel the fiscal push. Output stays put while the currency is stronger.

Step 5: Conclude.
So fiscal policy is powerless on output here, while monetary policy works through the exchange rate.
\[ \boxed{\text{Fiscal policy cannot change output under flexible rates}} \]