Flemming-mundell

Question 1

Swan diagram x and y axis

Answer 1

Y- axis: exchange rate in £/$: rise implies
depreciation of domestic currency and
improved international competitiveness.

X- axis: amount of real domestic
absorption: C+I+G

Question 2

Why does IB slope down in the swann diagram?

Answer 2

• Downward sloping: Appreciation reduces
exports and increases imports
• To maintain full employment, domestic
expenditure must rise

Question 3

why does the LM curve slope up?

Answer 3

Lm slopes up as high income leads to larger transaction balances, so if money supply given, they can only be draw out of speculative balance by a relatively large interest rate (Ms+Mt= MS)

Question 4

Why does the IS curve slope down?

Answer 4

IS slopes down as higher income means higher leakages, so interest must fall to stimulate investment and maintain balance between injections and leakages.

Question 5

Why does the BP curve slope up?

Answer 5

BP slopes up as high income means higher imports, so the current account deteriorates so Interest rate must increase so more capital flows in to balance BOP.

Question 6

What happens when LM and IS intersect either left or right of the BP curve?

Answer 6

Left of BP= BOP surplus

Right of BP= Bop deficit

Question 7

why do IS-LM intersect below full employment?

Answer 7

• IS-LM do not intersect at full employment
Yf because Yf planned leakages (S+M)
exceed planned injections (C+I+G), which
would build up stocks of unsold goods
leading producers to reduce output.

• Only at Y1 do leakages equal planned
injections.

Question 8

• Factors shifting the IS:

* Either G, C or I increase: IS shifts to the right

Answer 8

Explanation: increases in injections require
higher levels of Y to induce matching increases
in leakages.

Question 9

• Factors shifting the IS:
• An autonomous decrease of S or M : IS moves
to the right.

Answer 9

Explanation: A higher income is required to
induce more savings and import expenditure to
maintain leakages and injections equal

Question 10

• Factors shifting the IS:
• Depreciation of the exchange rate: IS
shifts to the right (provided MarshallLerner holds)

Answer 10

Explanation: Depreciation of the exchange
rate leads to a reduction of M and an
increase in X: injections exceed leakages,
requiring a larger Y to obtain equilibrium.

Question 11

• Factors shifting the LM:
• Increase in domestic money supply: LM shifts to the
right.

Answer 11

Explanation: At a given r, the increased money supply

will be held only if there’s an increase in income leading to a rise in transactions demand for money.

Question 12

• Factors shifting the LM:

Depreciation of the exchange rate shifts LM left

Answer 12

rise in price of
imports: rise in aggregate price index: reduction in real
money balances: increase in the demand for money, that
can only be eliminated by reducing the transactions
demand for money through lower income

Question 13

Factors shifting the BP
• Autonomous increase in X and autonomous
decrease in M: improvement of the BP: BP shifts
to the right

Answer 13

to induce a sufficient increase in M to

maintain equilibrium, as BOP has improved from an increase of X

Question 14

if there is an excess supply of money, what happens to the exchange rate?

Answer 14

depreciates

Question 15

how to have IB and EB?

Answer 15

Fiscal expansion under fixed rate with contractionary monetary policy.
oR

monetary expansion under floating.

Question 16

7 Limitations of flemming?

Answer 16

• Assumes ML condition holds even in the short run

• Neglects long- run budget constraints: in the long run,
private sector earnings equal disposable income, and
government expenditure equal taxation

• Absence of wealth effects: model has a short- term
nature

• Aggregate supply totally elastic: increases in aggregate
demand don’t lead to increases in general price level

• Treatment of capital flow: if r increases, model
assumes a continuous inflow of foreign capital.
Unrealistic: as foreign investors re- arrange
portfolios, capital inflow ceases

• static exchange rate expectations. Assumption more
unrealistic under flexible exchange rates

• Ignores interactions between stocks and flows: CA deficit
can be financed by capital inflow, long run: stock of
foreign liabilities increases: worsening of future CA, as
interest is paid

Question 17

why EB slopes up in swann diagram

Answer 17

• Upward sloping: depreciation of exchange
rate will increase exports and reduce
imports
• Domestic expenditure has to increase to
offset the decrease in imports