Under Mundell flemming model, in expantionary fiscal policy if there is high capital mobility then real interest rate rises due to crowding out effect. But under contractionary fiscal policy the real interest rate falls. I would like to know the reason why does it falls?
Does it because the government reduces its spending, which reduces the demand for loanable funds, leading to a decrease in interest rates?
Yes. You are correct. Under contractionary fiscal policy, Govt. Expenditure < Govt. Revenue. Due to this, there is less demand for borrowing and as a result of which the interest rates decrease.