Question

In 1979, the Federal Reserve Board sought to lower inflation in the U.S. through a contractionary monetary policy. GDP fell much more severely than expected, as did the rate of inflation. Why would the open-economy IS/LM/BP model do a better job of explaining the depth of the recession and the rapid decline in inflation than the closed economy IS/LM model?

Answer 1

Let's take a case where FED decrease the money supply in order to implement the contractionary monetary policy. With the decrease in money supply, the traditional LM curve will shift to left. This will reduce the output and increase the interest rate. With the decrease in output, the unemployment increase which led to decrease in consumer demand. These affected the overall goods market by shifting the IS curve towards left hereby bringing the equilibrium at less than full employment level. This is the case that occurs at closed IS/LM economy.

There is slight variation in IS-LM-BP model. With contractionary monetary policy, the LM curve shifts left. If the economy has a flexible exchange rate system then this decrease in LM curve will lead to appreciate the domestic currency. The appreciation of domestic currency will make the domestic goods expensive and foreign good cheap. This global demand for domestic country goods will reduce thereby reducing the overall export. In this situation the foreign goods will be cheaper hence the demand of foreign good in the home country will increase thereby increasing the import. This gap of export and import will widen the gap of net export which will further lead to capital account deficit. Now this condition in the economy will lead to generating unemployment as more people will losing the job. The demand will fall hence shifting the IS curve leftwards. With the decrease in aggregate demand, the price will rise. Hence the economy will face the recession.