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 achi

eve output

stability

(Hint: Use Mundell

-

Fleming model)

.

What happens to the components of

demand?

Answer 1

When there is a decrease in foreign output and interest rate. it has a direct impact on the domestic country's export. as the interest rate of foreign country decrease under flexible interest rate then it has a direct impact o domestic country's BOP condition and domestic country's currency will be appreciated, which will reduce inflation because imports become cheaper and the lower prices lead to lower inflation. It makes imports more attractive, causing the demand for local products to fall. As the demand for domestic product decrease the IS curve will shift left. also, the reason for the IS curve to shift left is the low supply of import goods as the output decrease.

In overall condition, the flexible exchange rate brings BOP from horizontal to surplus one. In this situation, the domestic position will be in a position with low output and high-interest rates. So the new equilibrium will be Y3 from Y1 with a higher interest rate i2.

The domestic country will reduce the import due to the high price impact of low output produced in a foreign country. so to fulfill the gap there will be a shift in demand for domestic goods which will be cheaper compared to the foreign good. So there is a shift in IS2 to IS3 and along with new changed LM1, will bring back the equilibrium to the original output Y1 with a high-interest rate i3. here there is a parallel shift in BP from BP2 to BP3.