Question

How do I go about showing in an IS - LM - IP diagram a decrease of interest rates but an increase in the exchange rate?  

Answer 1

THE IS-LM-IP or the IS-LM-IP model is also called the Mundell Fleming model where we examine the relationship between the interest ratea and the equilibruim in the goods and money market and external balance of payments equilibirum. The case mentioned in the question can be explained as follows -

To show a simultaneous increase in exchange rate (home nation currency depreciation) along with an increase in the rate of interest, we need to consider a shift in the IP curve. This can be drawn as shown in the diagram above. In this, we can see that the initial point of equilbrium is point E1 where the goods market, money market as well as the external balance are maintained. As we reduce the interest rates from r1 to r2, the IP curve will shift from IP1 to IP2, and as a result, the national income is increased from Y1 to Y2. The corresponding money market equilibrium is obtained by the increase in the money demand at this lower interest rate, as the LM curve also shifts to the right from LM1 to LM2. The new equilibrium E2 is still on the IS curve so it is still in equilibrium in the goods market.

There is increase in national income as when the exchange rate increases, or equivalently we can also say that the domestic currency has depreciated in such a way that we have to pay more of the domestic currency to get one unit of the foreign currency, the imports become more expensive and hence reduce, whereas the domestic exports to other countries become cheaper and hence increase in demand. As a result of this, we get a favourable external balance, the export earnings are more than import expenditure, and the national income increases.