Question

Discuss the effects on consumption, investment, and net exports in an economy operating under flexible exchange rates when the following policies take place.

a. A monetary expansion

b. A fiscal expansion.

Answer 1

a) When there is monetary expansion is expansion of money supply in the market. Assuming there is no change in prices, real money stock increases and there is an excess supply of real balances. To accommodate this increase and to maintain equilibrium interest rate goes down or income must increase. Due to this LM curve shifts rightwards to LM'.

This leads to decrease in domestic interest rate. Now this interest rate is below the world's interest rate so there will be capital outflow. To maintain the balance of payment, the exchange rate will depreciate. Now domestic goods have become cheaper to the foreigners so exports will increase. Also, the foreign goods have become more expensive to domestic consumers so imports will decline. Therefore net exports will increase. To accommodate this increase, domestic output increases and it causes IS curve to shift outwards until the old interest rate has been reached. This is shown below:

So the original interest rate is achieved. There is no change in investment. Since because of excess of money supply, income is also increasing, therefore there is a possibility of increase in consumption. Net exports increases.

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b) Fiscal Expansion: Fiscal expansion refers to policies such as tax cuts or increase in government spending. Due to fiscal expansion there is an increase in demand for output. At initial rate of interest and exchange rate, there is an excess demand now. Hence consumption will increase. This causes IS curve (investment saving curve) to shift outward.

IS curve shifts from IS to IS'. This causes interest rate to go up, and the new equilibrium is reached where the new IS curve intersects the LM curve. However at this new equilibrium, the domestic interest rate is higher than world interest rate. Assuming perfect capital mobility, capital will tend to move into the country and this will cause surplus of balance of payment. Currency will appreciate in response. Now domestic goods will become more expensive to foreign consumers so exports will decline. Also imports goes up since foreign goods have become cheaper. So overall net exports decline. Therefore total demand for output will go down and IS curve will start shifting inwards until the original equilibrium point is reached.

Hence consumption will increase, net exports will decrease and there is no change in investment,