Question

using a suitable diagram, explain clearly if a country that is open to international capital flows can control its domestic interest rate and fix its exchange rate.

Answer 1

The free flow of international capital into and from domestic market and the fixation of domestic interest rate and foreign exchange rate can be discussed in two ways. First under the fixed exchange rate and second under the flexible exchange rate. In both cases the government can control the domestic exchange rate and foreign exchange rate by adopting suitable monetary and fiscal policies.

Under Fixed exchange rate

When the money supply increased by the government by suitable monetary policy the LM curve shift from LM to LM1. Then the equilibrium moves from E0 to E1. Here the new equilibrium is below the balance of payment curve which shows a deficit in the balance of payment. As the exchange rate is fixed government intervention is needed. Here the government will purchase domestic currency by selling bonds. Thus the LM curve shift LM1 to LM and the original equilibrium is restored at Eo.

When the government its fiscal policy the iS curve shift from IS to IS1 which moves the equilibrium from E0 to E1. Here the economy has a balance of payment surplus , the government will sell domestic currency by purchasing bonds. This will increase the money supply shiftin the LM curve to the right and a final equilibrium is reached at E2. Here production has increased at the same interest rate. Hnce fiscal policy is more effective than monetary policy in controlling domestic interest rate and foreign exchange rate.

Under flexible exchange rate.

An expansion in monetary policy cause a shift in LM curve to LM1 which shift the equilibrium form E0 to E1. As the exchange rates are flexible the deficit in the balance of payment depreciate the national currency. A depreciation in national currency stimulate more export which will shift the IS curve to upward Thus a new equilibrium is reached at E2 with more output at the same interest rate. Monetary policy is more effective under this situation.

The expansion in fiscal policy shifts the IS curve from IS to IS1 which changes he equilibrium from E0 to E1. Since the country has a balance of payment surplus. The country’s currency will appreciate in the international market. This will decrease the export from the country. Thus the shortage in export reduce income output and employment which further shift the IS curve back to its original position. The final equilibrium is E2 is exactly equal to original equilibrium E0. So fiscal policy has no effect under flexible exchange rate to control interest, output, and employment.