Question

Examine the effects of a decrease in foreign output and foreign interest rate under

flexible - exchange rate regime when the goal of the central bank is to achieve output stability

(Hint: Use Mundell-Fleming model) What happens to the components of demand?

Answer 1

If there is a decrease in the foreign output and foreign interest rate, it can mean that the domestic interest rates have increased, and in general it will mean that there is capital inflow in the economy. The following steps can be seen -

1. When the foreign interest rates reduce, the foreign investors start investing in domestic bonds to get more interest and hence, there is an inflow of capital.

2. When the foreign output reduces, it means that the domestic output demand in the foreign market also increases.

3. As a result of these two factors, in a flexible exchange rate system, there will be an appreciation of the domestic currency. This is because the foreign demand for domestic currency will increase as more foreign investors are looking to invest in the domestic economy and other countries will demand more domestic currency to pay for their imports.

4. The IS curve will be shifted to the right. This is because the domestic investment will increase in this case.

5. The LM curve will shift to the right as well. This is because due to the appreciation of the exchange rate, the money demand will fall as exports fall.

6. As a result of this, the overall national output falls from its original level, but is still at equilibrium at the point where the goods market is in equilibrium with the money market.

Consider the following diagram -

Initial: IS1, LM1, equilibrium A, exchange rate e1 and national output Y1.

Final: IS2, LM2, equilibrium B, exchange rate e2 and national output Y2.

Here, e1 > e2, but we say that the currency has appreciated because here "e" in the home currency value of the foreign currency. Hence, a larger value of "e" would mean that more home currency units are required to purchase one unit of foreign currency. Hence, if "e" reduces from "e1" to "e2", it means that less home currency is being used to purchase one unit of foreign currency, hence, the home currency has appreciated.