Question

Using the IS–LM model, illustrate and explain how each of the following scenarios affects the home country. Compare the outcomes when the home country has a fixed exchange rate with the outcomes when the home currency floats.

1. A decrease in Home Country’s Money Supply
2. The home country cuts taxes (Decreases the tax rate).

Answer 1

IS-LM model shows the equilibrium in the money market and the goods market.

LM curve is the curve where every point on the curve shows the equilibrium in the money market. It shows the relationship between real output level and interest rates in the money market. It is generally upward sloping because given the money supply as the level output increases in the economy the interest rates also rises.

IS curve shows the equilibrium in the goods market. It shows the relationship between real output level and interest rate in the goods market. It is downward sloping because when interest rate falls, the demand for investment increases and thus the level out output / income in the economy also increases.

Intersection of IS-LM curve shows the equilibrium level in the economy where both money market and the goods market are in equilibrium.

1. A decrease in Home Country’s Money Supply

As money supply decreases in the economy, the interest rate(r) is higher at each level of output(Y), therefore the LM-curve will shift leftwards.

When economy is facing floating exchange rate;

As money supply decreases, LM curve shifts leftwards from LM to LM'. As a result the equilibrium level of output falls from Y to Y' and real interest rate also falls from r to r'.

When economy is facing fixed exchange rate;

When exchange rate is fixed, it means that interest rate cannot change in the economy so as LM curve shift leftwards, the new output level falls below the equilibrium level Y. So, to get back at equilibrium level of interest rate economy have to either increase their money supply so, LM curve shifts back to LM or to shift IS curve leftwards by decreasing government spending or increasing taxes.

2. The home country cuts taxes (Decreases the tax rate).

As tax rate is reduced in the economy, the IS curve will shift rightwards.

When economy is facing floating exchange rate;

IS curve will shift right from IS to IS'. As a result equilibrium level of output increases from Y to Y' and equilibrium level of interest rate redeuces from r to r'.

When economy is facing fixed exchange rate;

When exchange rate is fixed, it means that interest rate cannot change in the economy so as IS curve shift rightwards, the new output level falls above the equilibrium level Y. So, to get back at equilibrium level of interest rate economy have to either decrease their money supply so, LM curve shifts leftwards or to shift IS curve leftwards by decreasing government spending or increasing taxes.