In the Mundell-Fleming model on a Y - e graph, the curves labeled IS* and LM* are labeled that way as a reminder that:
A)the price level is held constant at the world price level p*.
B)the interest rate is held constant at the world interest rate r*.
C)the exchange rate is held constant at the world exchange rate e*.
D)output is held constant at the full employment level.

Question

Quizplus · Accepted Answer

The Mundell-Fleming model assumes that the exchange rate is fixed in the short run, so option C is incorrect. While the model does assume full employment, it is not necessary to hold output constant for the IS* and LM* curves to be labeled that way, so option D is also incorrect. The IS* curve represents the equilibrium condition in the goods market, while the LM* curve represents the equilibrium condition in the money market. Both of these equilibria are affected by changes in the interest rate, so the curves are labeled IS* and LM* to remind us that the interest rate is held constant at the world interest rate. This assumption allows us to analyze the effects of changes in other exogenous variables on output and the exchange rate.

In the Mundell-Fleming Model on a Y - E Graph