Question

1. This question is about the IS-LM-FX model. Assume Home and Foreign are in an initial equilibrium with a fixed exchange rate. Then the Home government decides to lower government spending, G.

2. 1. Describe the initial impact of this policy on the Home nominal interest rate, exchange rate, money supply and real output, holding Foreign interest rates and real output constant. You do not need to provide the graph in your solution, but you may find it useful to draw for yourself. (2 pts)

1. 2. Now describe the impact of Home’s policy on Foreign’s nominal interest rate, money supply and real output, taking as given the changes in Home’s variables you found in part a) as given. (1 pt)

2. 3. Now suppose that Home has decided that Home’s G must fall, but Home reaches out to Foreign to coordinate a monetary policy response. Describe a joint monetary policy that can (at least partially) stabilize both Home and Foreign output without sacrificing the fixed exchange rate. (1 pt)

Answer 1

In the IS-LM -FX model there are three impacts we have to find , first on keynesian crosss, then on IS -LM curve and lastly on forex market when government spending in domestic market decreases.

• Goods market or Keynesian cross - Fall in Govt. expenditure taking everything else constant reduces the Aggregate expenditure an the actual expenditure curve shifts downwards.
• IS-LM curve - When Aggregate expenditure falls, real output falls and shifts IS curve inside. This reduces liquidity of money as the new IS curve intersects LM curve at a lower point from before. Under fixed exchange rate the Central bank will intervene in forex market to maintain the currency at fixed rate ( i.e. peg). Therefore it buys back domestic currency and sells foreign currency to an extent that domestic currency does not appreciate.Selling of foreign currency reduces fall in domestic money supply so LM curve contracts.Here interest rates are constant or maintained at original level. (in line with fixed exchange rate interest rate parity)
• However there is no change in exchange rate as monetary policy has intervened to keep exchange rate fixed. Also it reduces current account deficit.

Since it is an open economy under fixed exchange rate,there will be rise in money supply in foriegn and fall in Home currency reserves kept by Foreign. Rise in money supply will boost foriegn's growth and output and output will expand, causing both inflation and interest rates to rise overtime.

Under calibrated monetary policy or monetary policy coordination if Home is decided that it will reduce government spending then Foreign in order to prevent unholding of Home currency reserves, will reduce domestic money supply beforehand as incoming money will raise inflation rates and worsen current account deficit.. This also prevents sudden increase of money supply in foriegn and gives time for foreign economy to adjust.