Question

Suppose a large open economy with fixed exchange rate.

A. What happens to income, interest rate in response to a fiscal expansion?

B. What happens to income and interest rate if the central bank expands money supply by buying bonds from the public?

Answer 1

Let us answer these questions with the help of the IS-LM framework assuming perfect capital mobility.

Answer to the question no. 2. a:

When a fiscal expansion takes place, this shifts the IS curve to the right and the LM remain the same. This activity will increase the interest rate in the home nation with relation to the foreign nation. The foreign investors will find it profitable to invest in the home nation and capital inflow will take place. This will incerase the demand for the home currency and thereby the home currency will appreciate and the exchange rate fall in favour of the home nation. To control this appreciation (fixed exchange rate) the home nation will supply more and more of the home currency and thus the money supply will increase. An increase in the money supply will cause the LM curve to shift to the right. and the home interest rate and the foreign interest rate will become equal and the exchange rate will again be restored at the equilibrium rate. However, this will increase the income of the nation further and the interest rate will remain at the former level. Thus, under fixed exchange tate regime, the fiscal policy is perfectly effective.

Answer to the question no. 2. b:

When the money supply is incerased and the monetary expansion takes place, the LM curve shift to the right. This cause the interest rate to fall with relation to the foreign nation. The foreign home will find it profitable to invest in the foreign nation and capital outflow takes place. This will incerase the demand for the foreign currency and thereby the home currency will deppreciate and the exchange rate will increase in favour of the foreign nation. To control this deppreciation (fixed exchange rate) the home nation will buy more of the home currency and supply the foreign currency. Buying of home currency will decrease the money supply in the economy and the LM curve again will shift to the formal level and the income, output and also the rate of interest does not change. And thus, the monetary policy under the fixed exchange rate regime is perfectly ineffective.