In a small open economy with a flexible exchange rate, an increase in autonomous consumption shifts the IS curve rightward, while a sudden capital outflow reduces net capital inflow by 10% and shifts the BP curve leftward. Using the Mundell–Fleming framework, explain qualitatively the impact on (i) national output, (ii) domestic interest rate, and (iii) exchange rate.
Answer
Output rises, domestic interest rate falls, exchange rate depreciates
The correct answer is Output rises, domestic interest rate falls, exchange rate depreciates — Lower interest rate relative to foreign rates causes depreciation of the domestic currency.
Step-by-step solution
- Rightward IS shift raises output for a given interest rate.
- Leftward BP shift makes it harder to maintain the same interest rate, leading to a lower domestic interest rate.
- Lower interest rate relative to foreign rates causes depreciation of the domestic currency.
Common mistake: Assuming output falls due to lower interest rate
Concept tested: Mundell–Fleming analysis
Published · How this solution was prepared and checked
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