Chapter 13, Problem 1QQ

To determine

The change in the factor that causes the increase in the income.

Answer to Problem 1QQ

Option 'a' is correct.

Explanation of Solution

The IS LM framework of the economy deals with the closed economy. It does not consider the international trade and balance of payments into consideration. This leads to the generation of the new model that incorporated the balance of payment into the calculations  known as the Mundell Fleming model.

Option (a):

When the exchange rate is floating under the Mundell Fleming model, the increase in the money supply reduces the rate of interest in the economy. The lower interest rate increases the investment expenditure and as a result, more employment will be generated in the economy leading to higher level of income in the economy. Thus, increase in the money supply increases the income level in the economy. Therefore, option 'a' is correct.

Option (b):

When there is a decrease in the money supply in the economy, it would reduce the money in circulation. As a result, the interest rate in the economy would increase. The higher the interest rate, the higher will be the investment from abroad. The higher demand for the domestic currency would further increase the rate of interest and this decreases the investment level as well as the income in the economy. Thus, option 'b' is incorrect.

Option (c):

The higher taxes decreases the disposable income of the people. The lower the disposable income is, the lower would be the savings rate in the economy. Since the changes in the tax rates are part of the fiscal policy of the government, there will be no impact on the aggregate income level of the economy. Thus, option 'c' is incorrect.

Option (d):

The lower taxes increases the disposable income of the people. Under the floating exchange rate system, there will be no impact over the aggregate income of the economy due to the fiscal policy. Since the changes in the tax rates are part of the fiscal policy of the government, there will be no impact on the aggregate income level of the economy. Thus, option 'd' is incorrect.

Economics Concept Introduction

Mundell - Fleming model: The Mundell Fleming model is the extended version of the  IS-LM model of the economy that incorporates the BOP into the equilibrium. Thus, it is the model that portrays the short run relationship between the nominal exchange rate of the economy, interest rate and the output.