Question

Consider the case of France following World War II. It is beginning a temporary period of expansionary government spending as it rebuilds its damaged infrastructure. And it is considering whether to join the system of fixed exchange rates being set up at that time, called the Bretton Woods System.

a) Suppose first that France undertakes its temporary expansionary fiscal policy while maintaining a flexible exchange rate. State the short-run effects of the fiscal policy on France’s output, interest rate, and exchange rate, using the IS-LM and Forex Market graphs to show this.

b) Suppose instead that France fixes its exchange rate and then undertakes the temporary expansionary fiscal policy. State the short-run effects on France’s output, interest rate and exchange rate, using the IS-LM and Forex Market graphs to show this. Explain each curve shift. Compare the result to your answer in part (a).

Answer 1

A) if France takes the expansionary fiscal policy with the exchange rate flexible.

Expansionary fiscal policy will lead to a shift in the IS curve to IS1. The rate of exchange and the output will increase. This increase in the IS curve will lead to an increase in the demand and lead to a shift in the demand curve from D to D1. There will be an increase in the exchange rate from I to I1. The output will also increase from Y to Y1.

B) if the exchange rate is fixed and then an expansionary fiscal policy is taken up.

The expansionary fiscal policy will lead to an increase in the IS curve. The rate of interest and output will increase. In the forex market, there will be an increase in the demand which will lead to an increase in the exchange rate. But since the exchange rate is fixed, the supply will increase in order to get the market into equilibrium. The exchange rate will remain unchanged whereas the output will increase.

Comparison between a and b

We see that under the flexible exchange rate the exchange rate changes or increases than before but under the fixed exchange rate it remains unchanged.

The output in the flexible exchange rate increases but under the fixed exchange rate the output increases more than the increase under flexible exchange rate. This is the key difference between the two.