Consider the case of a small open economy with a fixed exchange rate, perfect capital mobility...

Consider the case of a small open economy with a fixed exchange rate, perfect capital mobility (i.e., interest parity holds), and complete price stability (no ongoing inflation). Explain what effect a decrease in the world interest rate would have on the following domestic macroeconomic variables:

a. The stock of foreign exchange reserves. b. The money supply.
c. Real GDP.
d. The price level.

e. The real exchange rate.

Solutions

Expert Solution

Let us suppose that the world interest rate declines. This will have the following impact on the macroeconomic variables:

The effects explained in the diagram (given in the image below) are strictly based on the assumptions of the IS LM BP model. One major assumption being the constant price level. However, if this asumption is removed, we can say that with the rise in money supply price level will rise in the economy. This will lead to fall in the real exchange rate.

Rahul Sunny answered 1 week ago

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