ECS3703
Assignment 2
Semester 2 2025
Due September 2025
, ECS3703 Assignment 2
Semester 2, 2025 — Due: September 2025
Exceptionally Crafted
1. Expansionary Fiscal Policy in an Open Economy with Fixed
Exchange Rates
In an open economy under a fixed exchange rate system, the Mundell–Fleming
model combines the IS–LM framework with the balance of payments (BP) schedule to
explain macroeconomic adjustments.
Initial equilibrium: At the natural level of output Yn , goods market equilibrium (IS)
coincides with money market equilibrium (LM) and external balance (BP). With
perfect capital mobility, the BP curve is horizontal at the given world interest rate i∗ .
• Output is at Yn , i = i∗ .
• The exchange rate is pegged; the central bank intervenes to maintain it.
• BP equilibrium implies no net capital flows at i∗ .
Expansionary fiscal policy: An increase in G or cut in T shifts the IS curve right:
IS1 → IS2
Output rises, interest rates increase to i′ > i∗ , attracting capital inflows → BP surplus.
To maintain the fixed rate, the central bank buys foreign currency, increasing the
money supply → LM shifts right. This continues until i returns to i∗ but output is now
Y ′′ > Yn .
Conclusion: Fiscal policy is highly effective in this setting; however, excess demand
can cause overheating and inflationary pressures.
1
, i
LMLM
2 1
E1 E2
BP
IS2
IS1
Y
Yn Y ′′
Figure 1: Expansionary fiscal policy under fixed exchange rates with perfect capital
mobility.
2. Explain the difference between dollarization and an optimum
currency area. (10)
Dollarization occurs when a country unilaterally adopts a foreign currency (e.g.,
Ecuador using the US dollar) as legal tender, replacing its domestic currency. It is often
motivated by a desire to stabilise prices, curb hyperinflation, or restore credibility.
However, it eliminates monetary policy autonomy and seigniorage revenue, tying the
domestic economy to the foreign central bank’s policy.
An Optimum Currency Area (OCA), by contrast, is a set of regions or countries that
share a currency or maintain fixed rates due to high integration. According to
Mundell’s OCA theory, conditions include:
• High labour mobility across regions
• Fiscal transfers to offset asymmetric shocks
• Similar inflation rates and business cycles
• Deep trade and financial integration
Examples include the Eurozone, where members share the European Central Bank.
Key Differences:
• Dollarization is unilateral, with no shared governance.
• OCA is multilateral, with shared policy institutions.
2
Assignment 2
Semester 2 2025
Due September 2025
, ECS3703 Assignment 2
Semester 2, 2025 — Due: September 2025
Exceptionally Crafted
1. Expansionary Fiscal Policy in an Open Economy with Fixed
Exchange Rates
In an open economy under a fixed exchange rate system, the Mundell–Fleming
model combines the IS–LM framework with the balance of payments (BP) schedule to
explain macroeconomic adjustments.
Initial equilibrium: At the natural level of output Yn , goods market equilibrium (IS)
coincides with money market equilibrium (LM) and external balance (BP). With
perfect capital mobility, the BP curve is horizontal at the given world interest rate i∗ .
• Output is at Yn , i = i∗ .
• The exchange rate is pegged; the central bank intervenes to maintain it.
• BP equilibrium implies no net capital flows at i∗ .
Expansionary fiscal policy: An increase in G or cut in T shifts the IS curve right:
IS1 → IS2
Output rises, interest rates increase to i′ > i∗ , attracting capital inflows → BP surplus.
To maintain the fixed rate, the central bank buys foreign currency, increasing the
money supply → LM shifts right. This continues until i returns to i∗ but output is now
Y ′′ > Yn .
Conclusion: Fiscal policy is highly effective in this setting; however, excess demand
can cause overheating and inflationary pressures.
1
, i
LMLM
2 1
E1 E2
BP
IS2
IS1
Y
Yn Y ′′
Figure 1: Expansionary fiscal policy under fixed exchange rates with perfect capital
mobility.
2. Explain the difference between dollarization and an optimum
currency area. (10)
Dollarization occurs when a country unilaterally adopts a foreign currency (e.g.,
Ecuador using the US dollar) as legal tender, replacing its domestic currency. It is often
motivated by a desire to stabilise prices, curb hyperinflation, or restore credibility.
However, it eliminates monetary policy autonomy and seigniorage revenue, tying the
domestic economy to the foreign central bank’s policy.
An Optimum Currency Area (OCA), by contrast, is a set of regions or countries that
share a currency or maintain fixed rates due to high integration. According to
Mundell’s OCA theory, conditions include:
• High labour mobility across regions
• Fiscal transfers to offset asymmetric shocks
• Similar inflation rates and business cycles
• Deep trade and financial integration
Examples include the Eurozone, where members share the European Central Bank.
Key Differences:
• Dollarization is unilateral, with no shared governance.
• OCA is multilateral, with shared policy institutions.
2
