2. In the Mundell–Fleming model with fixed exchange rates, explain what happens to aggregate

Question

income, the exchange rate, and the trade balance when
A. taxes are reduced.
B. Government expenditure decreases
C. Central bank decreased money supply�

Answer 1

A. When taxes are reduced, disposable income increases, which leads to an increase in consumption and investment. This increase in aggregate demand leads to an increase in aggregate income. As a result, the exchange rate appreciates as domestic goods become more attractive to foreign buyers. This appreciation in the exchange rate leads to a decrease in the trade balance as exports become more expensive for foreign buyers.

B. When government expenditure decreases, aggregate demand decreases, leading to a decrease in aggregate income. This decrease in income leads to a depreciation of the exchange rate as domestic goods become less attractive to foreign buyers. The depreciation in the exchange rate leads to an increase in the trade balance as exports become cheaper for foreign buyers.

C. When the central bank decreases the money supply, interest rates rise, which leads to a decrease in consumption and investment. This decrease in aggregate demand leads to a decrease in aggregate income. The exchange rate depreciates as domestic goods become less attractive to foreign buyers. This decrease in the exchange rate leads to an increase in the trade balance as exports become cheaper for foreign buyers.