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exchange rates

FINANCIAL ACCOUNTING
FINANCIAL ACCOUNTING
10th Edition
ISBN:9781259964947
Author:Libby
Publisher:Libby
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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In the Mundell-Fleming model with floating, exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when the money supply is reduced. What would happen if exchange rates were fixed rather than floating?
A reduced amount of money in the market will very quickly lead to an increase in the demand for money. As the demand for money grows, so do interest rates. Thus, domestic interest rates become higher than foreign ones which increases the demand for domestic currency. So the value of the domestic currency increases, while the value of the foreign currency decreases. Foreign goods will become cheaper, so there will be an increase in imports, while domestic goods will become more expensive and therefore there will be a decrease in exports. As less goods are exported, the production of goods will be reduced. This will lead to a reduction in the trade balance.
Transcribed Image Text:A reduced amount of money in the market will very quickly lead to an increase in the demand for money. As the demand for money grows, so do interest rates. Thus, domestic interest rates become higher than foreign ones which increases the demand for domestic currency. So the value of the domestic currency increases, while the value of the foreign currency decreases. Foreign goods will become cheaper, so there will be an increase in imports, while domestic goods will become more expensive and therefore there will be a decrease in exports. As less goods are exported, the production of goods will be reduced. This will lead to a reduction in the trade balance.
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