Question

Compare the Closed-Economy IS-LM model, an Open-Economy IS-LM-BP model in which exchange rates are allowed to float freely, and an Open-Economy IS-LM-BP model in which exchange rates are held constant by the central bank. Specifically, use the three models to explain, and compare, the effects on GDP, interest, and the exchange rate of the national currency of:

a. A sudden increase in government expenditures.

b. A sharp increase in the discount rate and a massive sale of Treasury bonds by the central bank.

Answer 1

For a closed economy IS-LM model depicts the equilibrium for good, labours credit and money market, where IS curve reflects the market for goods and services and LM curve reflects the money market.

For open economy IS-LM-BP model we can say that it is the international version of typical IS-LM model where along with the equilibrium in goods and money market it considers the equilibrium anaysis of balance of payments.

a) if govt increases suddenly its expenditures IS curve for the case of closed IS-LM economy will shift to the right, planned expenditure will go up thus production will be higher and consumption and investment will also be higher. Thus, GDP will increase in the case of closed economy  to meet the new equilibrium interest rate will higher eventually.

In the open economy IS-LM-BP model if there is fixed exchange rate that means there is imperfect capital mobility and BP is steeper than LM and if govt increases its expenditure , IS curve will shift to the right thus at the new intersecting point there will be BOP deficit , domestic currency will be depreciate, net export will increase that will shift IS curve towards more right and BP curve will also shift to the right to a new equilibrium level.

For open economy IS-LM-BP model with fixed exchange rate if govt increases its expenditure IS curve will shift to the right and economy will have balance of payment surplus , to have the new equilibrium level govt will follow policies to increase the money supply and LM curve will shift to the right to have the new equilibrium level where at the same interest rate economy will face a higher GDP.

b) A sharp increase in the discount rate and a massive sale of treasury bonds will decrease the money supply of the economy.

for closed economy, due to fall in the money supply LM curve will shift to the left increasing the interest rate and the output will fall eventually to a new low point of equilibrium.

for open economy, with fixed exchange rate if money supply decreases LM curve will shift to the left thus equilibrium will go up but due to BOP surplus at the new equilibrium level , govt will intervent to increase the money supply and the economy will be in the previous level of equilibrium.

open economy when exchange rate can float economy will face a new equiibrium with lower GDP cause decrease in money supply will shift the lm curve left there will be BOP surplus is curve will shift left bop curve will shift also shift left.