Question
In the Mundell-Fleming model with a floating exchange
rate and perfect capital mobility, what is the effect of an increase in the money supply?Solution
Under a floating exchange rate with perfect capital mobility, an increase in the money supply shifts the LM curve to the right, reducing the interest rate. This leads to capital outflows, causing the domestic currency to depreciate. The depreciation makes domestic goods cheaper for foreigners, increasing net exports and thus increasing output.
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