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Economics 3422
Sample Quiz 6
Multiple choice. Choose the best alternative that answers or complete the sentences.
Answer questions 1 – 8 with reference to the Mundell-Fleming diagram below.
BP
LM
i
a
1
II
I
2
b
IS
Y
1.
A contractionary fiscal policy shifts
a.
b.
c.
d.
2.
An expansionary monetary policy shifts
a.
b.
c.
d.
3.
the IS curve to the right to a point such as “2”
the IS curve to the left to a point such as “1”
the LM curve to the right to a point such as “b”
the LM curve to the left to a point such as “a”
the IS curve to the right to a point such as “2”
the IS curve to the left to a point such as “1”
the LM curve to the right to a point such as “b”
the LM curve to the left to a point such as “a”
Suppose following a disturbance that shifted one of the curves to a temporary equilibrium point “2”, at
point “2”,
a.
b.
c.
d.
there is a temporary BOP surplus and the domestic currency is under pressure to
appreciate/revaluate
there is a temporary BOP deficit and the domestic currency is under pressure to
appreciate/revaluate
there is a temporary BOP surplus and the domestic currency is under pressure to
depreciate/devaluate
there is a temporary BOP deficit and the domestic currency is under pressure to
depreciate/devaluate
4.
Suppose this is a fixed exchange rate economy, at the temporary equilibrium, point “2” in the diagram, in
order to prevent the domestic currency from changing, the domestic central bank must
a.
b.
c.
d.
5.
Suppose point “a” represents a point of temporary equilibrium after a disturbance that shifted one of the
curves, at point “a”,
a.
b.
c.
d.
6.
expand the domestic money supply, shifting the LM curve to the right
expand the domestic money supply, shifting the LM curve to the left
contract the domestic money supply, shifting the LM curve to the right
contract the domestic money supply, shifting the LM curve to the left
Assuming a flexible exchange rate economy, after a contractionary fiscal policy, and after all the
adjustments have taken place in the economy (i.e.., at the new final equilibrium), we can expect the
domestic interest rate to be __________, and the domestic income to be __________ than initially.
a.
c.
8.
there is a temporary BOP surplus and the domestic currency is under pressure to
appreciate/revaluate
there is a temporary BOP deficit and the domestic currency is under pressure to
appreciate/revaluate
there is a temporary BOP surplus and the domestic currency is under pressure to
depreciate/devaluate
there is a temporary BOP deficit and the domestic currency is under pressure to
depreciate/devaluate
Suppose this is a fixed exchange rate economy, at the temporary equilibrium, point “a” in the diagram, in
order to prevent the domestic currency from changing, the domestic central bank must
a.
b.
c.
d.
7.
expand the domestic money supply, shifting the LM curve to the right
expand the domestic money supply, shifting the LM curve to the left
contract the domestic money supply, shifting the LM curve to the right
contract the domestic money supply, shifting the LM curve to the left
lower, higher
higher, lower
b.
e.
lower, lower
higher, higher
Suppose this is a fixed exchange rate economy, following an expansionary monetary policy, the new final
equilibrium is at point
a.
c.
e.
“b” on the IS curve
b.
“2” on the LM curve
d.
the same as before the monetary expansion
“II” on the BP curve
cannot be determined
Part B:
In the context of a Mundell-fleming model under a fixed exchange rate system, explain why an expansionary fiscal
policy is more effective in affecting output when there is a greater degree of capital mobility (i.e., when the BP
curve is less steep)?
Solution:
1. b; 2. c; 3. d; 4. d; 5. a; 6. a; 7. b; 8. e
Part B: The main reason is that the greater the degree of capital mobility, the less will be the crowding-out of
domestic investment due to the expansionary fiscal policy. For example, in the case of perfect capital
immobility, following an expansionary fiscal policy, domestic money supply must decrease in order to return to
equilibrium. This causes domestic interest rate to rise further and resulting in a complete crowding out. On the
other hand, in the case of perfect capital mobility, domestic money supply must increase to return to
equilibrium. This causes domestic interest rate to remain the same, and no crowding out of domestic
investment.