Solution To Section-A and Section-C Of BECC-106 TEE

Section—A

1. As per the Mundell-Fleming model, explain the conditions under which monetary policy and fiscal policy are effective.

The Mundell-Fleming model (an open-economy extension of IS-LM) analyzes short-run macroeconomic policy effectiveness under perfect capital mobility, fixed prices, and different exchange rate regimes. It highlights the “impossible trinity”: a country cannot simultaneously have fixed exchange rates, free capital mobility, and independent monetary policy.Under flexible (floating) exchange rates with perfect capital mobility:

• Monetary policy is highly effective in influencing output (Y). Expansionary monetary policy shifts LM right, lowering domestic interest rate (i) below world rate (i*). Capital outflows ensue, depreciating the exchange rate (e rises). Depreciation boosts net exports (NX), shifting IS right. The net effect is a large increase in Y, with i returning to i* (via capital flows). Fiscal policy is ineffective: expansionary fiscal shifts IS right, raising i above i*, attracting inflows, appreciating e, reducing NX, and shifting IS back left. Y remains unchanged (crowding out via exchange rate).

Under fixed exchange rates with perfect capital mobility:

• Fiscal policy is highly effective. Expansionary fiscal shifts IS right, raising i above i*, attracting inflows. To prevent appreciation, the central bank buys foreign currency (increasing money supply), shifting LM right until i = i* and Y rises significantly.
• Monetary policy is ineffective. Expansionary monetary shifts LM right, lowering i below i*, causing outflows. To defend the fixed e, the central bank sells foreign reserves, contracting money supply back (LM shifts left). Y unchanged.

Key assumptions: perfect capital mobility (horizontal BP line at i = i*), small open economy (i* exogenous), fixed prices (short-run focus). The model shows policy assignment: under floating rates, assign monetary policy to internal balance (output); under fixed rates, assign fiscal policy to internal balance, monetary to external (reserves).

Implications: floating rates insulate from foreign shocks via e adjustment but limit fiscal stimulus. Fixed rates allow fiscal activism but tie monetary to external balance, explaining trilemma trade-offs in practice (e.g., Eurozone constraints).

2. With the help of Swan diagram, explain the different scenarios of external and internal imbalance in an economy.

The Swan diagram (developed by Trevor Swan in 1955, also called Salter-Swan) analyzes internal and external balance in a small open economy using two instruments: domestic absorption/expenditure (A, horizontal axis) and real exchange rate (q or e/P, vertical axis, higher q = depreciation).

• Internal balance (IB) curve: combinations of A and q yielding full employment with price stability (no inflationary gap or recession). Slopes downward: higher q (depreciation) improves competitiveness, raises NX and output → requires lower A to avoid overheating. Rightward movement (higher A) causes excess demand/overheating.
• External balance (EB) curve: combinations yielding balanced current account (CA = 0, sustainable BoP). Also downward-sloping but flatter than IB: higher q boosts NX (surplus direction); higher A worsens CA (imports rise). EB steeper or flatter depending on trade elasticities, but typically IB steeper.

The intersection of IB and EB is the bliss point (full internal balance + CA = 0).Four imbalance zones:

• Zone I (above IB, left of EB): Inflationary + CA surplus. Overheating (high A, appreciated q) but strong exports.
• Zone II (above IB, right of EB): Inflationary + CA deficit. Overheating and excessive imports (high A, appreciated q).
• Zone III (below IB, right of EB): Recession + CA deficit. Underemployment and weak NX (low A, appreciated q or high A but very appreciated).
• Zone IV (below IB, left of EB): Recession + CA surplus. Underemployment but strong exports (low A, depreciated q).

Policy mix: Expenditure policy (fiscal/monetary) shifts horizontally (changes A); expenditure-switching (devaluation/revaluation) shifts vertically (changes q).Examples:

• CA deficit + inflation (Zone II): devalue (down) + contract A (left) → move to bliss point.
• CA surplus + recession (Zone IV): appreciate (up) + expand A (right).

The diagram shows why single policies fail: e.g., only devaluation fixes external but may cause internal imbalance. Optimal requires coordinated mix.Modern extensions incorporate capital flows, but core insight remains: internal/external targets need distinct instruments.

Section—C

12. Write short notes on any two of the following :

(a) Determinants of net exports

Net exports (NX = X – M) depend on:

• Real exchange rate (q = e P/P)*: higher q (depreciation) makes exports cheaper, imports dearer → NX rises (Marshall-Lerner condition if elasticities sum >1).
• Domestic income (Y): higher Y raises import demand → NX falls (income elasticity of imports positive).
• Foreign income (Y): higher Y raises export demand → NX rises.
• Relative prices and competitiveness: non-price factors like quality, tariffs, quotas.
• Tastes/preferences and trade policies.

In Mundell-Fleming, NX sensitive to e and Y; in long-run, determined by saving-investment balance (NX = S – I).

(c) Lucas supply curve

The Lucas supply curve (from Robert Lucas, 1972) explains short-run AS positively sloped due to imperfect information and rational expectations. Firms observe local prices but not overall P instantly (signal extraction problem). A surprise rise in P is misperceived as relative price rise → supply more output (positive slope). Under rational expectations, only unanticipated policy shocks affect output (surprise inflation raises Y above natural level). Anticipated policy neutral (vertical long-run AS). Explains why monetary surprises cause short-run booms; policy ineffectiveness proposition: systematic policy ineffective if anticipated. Contrasts adaptive expectations (short-run trade-off persists). Key in New Classical critique of Keynesian activism.