I'm currently learning the Mundell Fleming model, and so from my textbook and other sources I've figured out the effect of increase in money supply and government expenditure increase for the following conditions:
- Fixed & floating exchange rates (perfect capital mobility / BP horizontal)
- Fixed & floating exchange rates (imperfect capital mobility, BP flatter than LM curve)
- Fixed exchange rate (imperfect capital mobility, BP steeper than LM curve)
I'm stuck at figuring out the effect of a fiscal expansion in the case of floating exchange rate with the BP curve steeper than the LM curve. My textbook has not mentioned it but I'd like to how it'd turn out.
Here's my guess:
The economy is initially at the point A. There is fiscal expansion:
- IS moves to the right (1 to 2)
- At B, there is a deficit in BOP, which causes the domestic currency to depreciate.
- This increases exports and decreases imports, which causes net exports to increase, which then causes Y to increase, which shifts IS further up (IS 3).
- At B, because of increase in net exports, BOP improve and so BP also shifts to the right.
- The economy settles at the new equilibrium C.
Am I correct?