Question

Using the IS/LM/BP model, demonstrate the impact of the following events on the US

economy(use graph). Assume that the US has an upward sloping BP curve that is flatter (but not horizontal) than its LM curve. Assume that the exchange rate is flexible.

a) An increase in government spending

b)An increase in the money supply

c)An increase in foreign GDP

Answer 1

a)

Take the effects of fiscal policy ( an increase in government spending ) with initial equilibrium at point E, where IS= LM= BP curves and OR interest rate and OY income level . If an expansionary fiscal policy is adopted there is balance of payment deficit under flexible exchange rate. An increase in government expenditure will shift the IS curve to the right which cuts LM curve at E3 . This raises the interest rate to OR3. There is capital inflows which causes currency appreciation . This in turn raises imports and reduces export and leads to depreciation of currency, and IS1 curve shifts back to IS curve. Thus fiscal policy is ineffective under flexible exchange rate with relative capital mobility

b)

Suppose the monetary authority follows an expansionary monetary policy from the initial equilibrium position, the LM curve shifts to LM1 and intersects IS at E2. This leads to a deficit in balance of payment. There is capital outflow with a fall in interest rates. The country's exchange rate depreciates with an increase in demand for foreign currency. This increases export and decreases import,causing IS curve to shift to IS1. The balance of payment improve and the new equilibrium is at E1 . Thus an expansionary monetary policy is effective

c)

Higher foreign GDP leads to higher spending by foreigners on the domestic country's export, thus the net exports will be higher.