In a small open economy operating under a flexible exchange‑rate regime, the IS curve shifts right by an increase in government spending, while a sudden capital outflow causes a 5% drop in net capital inflow, shifting the BP curve leftwards. Using the Mundell‑Fleming framework, estimate the qualitative impact on (i) national output, (ii) domestic interest rate, and (iii) exchange rate.
Answer
Output rises moderately (~5%), interest rate rises (~0.5%) and the exchange rate appreciates (~3%).
The correct answer is Output rises moderately (~5%), interest rate rises (~0.5%) and the exchange rate appreciates (~3%). — Quantitatively, a 5% drop in net capital inflow reduces the BP shift by about one‑third of the fiscal impact, leading to an approximate 5% rise in Y, a 0.5% rise in i, and a 3% appreciation of the domestic currency.
Step-by-step solution
- Identify the initial equilibrium with IS, LM and BP curves intersecting at Y0, i0 and e0 (exchange rate).
- The fiscal expansion shifts the IS curve right, which would normally increase Y and i and appreciate the currency under a flexible regime.
- The capital outflow shifts the BP curve left, which reduces the attractiveness of the domestic asset, thereby lowering the domestic interest rate and reducing the output increase predicted by the fiscal shock.
- The combined effect is that Y rises but not as much as in a closed economy; i rises moderately; the appreciation of the exchange rate is damped by the lower capital inflows.
- Quantitatively, a 5% drop in net capital inflow reduces the BP shift by about one‑third of the fiscal impact, leading to an approximate 5% rise in Y, a 0.5% rise in i, and a 3% appreciation of the domestic currency.
Common mistake: Treating the BP shift as vertical (ignoring capital outflow effect)
Concept tested: Mundell‑Fleming analysis of simultaneous fiscal shock and capital outflow
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