Question

Suppose that under a fixed exchange rate system, a country starts at both internal and external balance. What happens to the internal and external balance curves if investment spending falls in the rest of the world?

Answer 1

An internal equilibrium is achieved at the full employment and stable prices. If there is an inflationary pressure or unemployment, the economy will reuire further adjustment in prices or move toward the full employment output level.

i) Product Market: y(1-b+m)= a+i()+g+x; b = Marginal Propensity to Consume, m= Marginal Propensity to Import

ii) Money Market: = l(r)+ky; l(r)= liquidity balance, ky= transactions balance (k>0, not capital-labour ratio).

An internal equilibrium is attained when the output is at the full employment level. An increase in g shifts the IS curve to the right , thereby raising the the interest rate. Moreover because the economy is fully employed real output cannot increased beyond .thus an increase in g increase inflationary pressure thereby raising domestic price which shifts Lm curve to the left. thus along the IE curve government spending and interest rate are directly related.