Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Mundell-Fleming model specifically analyze?

1. Effects of inflation on open economies

2. Interactions between monetary and fiscal policy in small open economies

3. Comparative advantage in trade

4. Effects of trade tariffs on currency valuation

The correct answer is: Interactions between monetary and fiscal policy in small open economies

The Mundell-Fleming model specifically focuses on examining the interactions between monetary and fiscal policy within small open economies, particularly under different exchange rate regimes. This model is an extension of the IS-LM framework, which analyzes aggregate demand in a closed economy, incorporating the external sector to understand how an economy interacts with international markets. In the context of small open economies, the Mundell-Fleming model highlights how capital mobility influences the effectiveness of fiscal and monetary policies. For instance, under fixed exchange rates, monetary policy is less effective because any change in interest rates could lead to capital outflows or inflows that pressure the exchange rate, while fiscal policy can be more effective as it directly impacts domestic demand. Additionally, the model distinguishes between various scenarios—like flexible versus fixed exchange rates—and elucidates the trade-offs policymakers face when trying to manage their economy's output and inflation in an open context. This helps to understand better how policies can be coordinated to achieve desired outcomes in a globalized economic environment, emphasizing the significance of external factors on national economic policy effectiveness. The other options such as the effects of inflation on open economies, comparative advantage in trade, and effects of trade tariffs on currency valuation do not capture the main focus of the Mundell-F