What would happen to the exchange rate and net exports in our open economy IS-LM if...

What would happen to the exchange rate and net exports in our open economy IS-LM if the U.S. imposed new regulations to restrict capital inflow?

Expert Solution

Restricted capital inflow decreases domestic savings. Lower savings shifts IS curve leftward, decreasing interest rate and output. Lower domestic interest rate increases net capital outflow, which in turn increases net exports and decreases exchange rate.

In following graph, panel A shows IS and LM curves. IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and initial output Y0. When IS0 left to IS1, it intersects LM0 at point B with lower interest rate r1 and lower output Y1.

In panel B (depicting net capital outflow as inverse function of interest rate), lower interest rate from r0 to r1 increases net capital outflow from NCO0 to NC01.

In panel C (depicting net exports as inverse function of exchange rate), an increase in net capital outflow from NCO0 to NCO1 increases net exports from NX0 to NX1 and decreases exchange rate from e0 to e1.

Rahul Sunny answered 2 years ago

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