Questions: Open Economy Macroeconomics (Mundell-Fleming)

Question 1

Under the Mundell-Fleming model with floating exchange rates and perfect capital mobility, a government sharply increases spending to stimulate the economy. What is the predicted effect on output?

• A. Output rises substantially because government spending directly increases aggregate demand
• B. Output is largely unchanged because the higher interest rate attracts capital inflows, appreciates the exchange rate, and reduces net exports, offsetting the fiscal stimulus
• C. Output falls because higher government spending crowds out private investment through higher interest rates
• D. Output rises and then falls as the exchange rate adjustment lags the fiscal stimulus by several quarters

Answer: (B)

Under floating rates with perfect capital mobility, fiscal policy is largely ineffective — this is one of the most counterintuitive Mundell-Fleming results. Fiscal expansion raises output and the interest rate; higher rates attract capital inflows; inflows appreciate the exchange rate; appreciation makes exports more expensive and imports cheaper; net exports fall, shifting IS back leftward. In the extreme perfect capital mobility case, the appreciation almost exactly offsets the fiscal stimulus, leaving output unchanged. The crowding out occurs through the exchange rate channel, not the interest rate channel.

Question 2

A country wants to maintain a fixed exchange rate with its major trading partners while preserving the ability to set its own interest rates to control inflation. According to the impossible trinity, what must this country sacrifice?

• A. Trade balance flexibility — it can no longer adjust the current account independently
• B. Free capital mobility — it must impose capital controls to maintain both the peg and monetary independence
• C. Fiscal policy independence — the exchange rate peg automatically constrains government spending
• D. The ability to ever adopt a floating exchange rate in the future

Answer: (B)

The impossible trinity states you cannot simultaneously have: (1) fixed exchange rate, (2) free capital mobility, (3) independent monetary policy. With a fixed rate + free capital mobility, any attempt to set domestic rates above or below the world rate triggers unlimited capital flows that force rates back to i*. To maintain both a peg and monetary independence, capital must be controlled — restricting the flows that would otherwise undermine one or the other. China's capital account controls are the canonical example of this trade-off in action.

Question 3

Under fixed exchange rates with perfect capital mobility, monetary policy is self-defeating: any attempt to change the domestic money supply is automatically reversed by capital flows and the exchange rate defense mechanism.

• T. True
• F. False

Answer: True

True — this is the core Mundell-Fleming result under fixed rates. If the central bank expands the money supply, the domestic interest rate falls below the world rate, triggering capital outflows, which puts downward pressure on the exchange rate. To defend the peg, the central bank must sell foreign reserves and buy domestic currency, contracting the money supply back to where it started. The process is self-defeating: monetary expansion is automatically undone by the peg defense. Fiscal policy is effective under fixed rates — monetary is not.

Question 4

Under floating exchange rates with perfect capital mobility, fiscal policy is highly effective because government spending directly raises output without being significantly offset by exchange rate movements.

• T. True
• F. False

Answer: False

False — this is precisely backward. Under floating rates with perfect capital mobility, fiscal policy is largely ineffective. Fiscal expansion raises interest rates, attracts capital inflows, appreciates the exchange rate, and reduces net exports — nearly fully offsetting the stimulus. It is under *fixed* exchange rates that fiscal policy is effective (because the peg defense automatically expands the money supply to accommodate the IS shift). And it is *monetary* policy that is highly effective under floating rates (because exchange rate depreciation amplifies the stimulus through improved net exports).

Question 5

Why did eurozone member countries during the 2010–2012 debt crisis face a 'double bind' when trying to respond to recession? Connect your answer to the impossible trinity.

Model answer: Eurozone members have a fixed exchange rate (the shared euro) and free capital mobility (required by the EU). The impossible trinity therefore requires they sacrifice independent monetary policy — the ECB sets rates for the entire zone, not individual countries. Under fixed rates, Mundell-Fleming says fiscal policy is effective. But the indebted periphery countries (Greece, Spain, Portugal) faced binding debt sustainability constraints that prevented expansionary fiscal policy. They were left with neither a monetary lever (no independent central bank) nor a usable fiscal lever (debt crisis) — hence the double bind. The crisis was in part a direct consequence of the corner of the impossible trinity they had chosen.

This example illustrates why the trilemma is not merely theoretical. The specific constraints of the eurozone architecture — monetary union without fiscal union — created a situation where the one tool the model said would work (fiscal policy) was constrained by market pressure on sovereign debt. Understanding the Mundell-Fleming model makes the crisis legible in a way that purely narrative accounts cannot.