Question

this question above .A country which adopts a fixed exchange rate system with perfect capital mobility should implement expansionary monetary policy to increase the aggregate income level, Do you agree with this statement and why you agree..i want explaination.

Answer 1

The above statement is correct.

Through making appropriate changes in monetary policy the government can influence the level of economic activity. Monetary policy may also be expansionary or contractionary depending on the prevailing economic situation. A change in the money supply causes a shift in the LM curve. An increase in the money supply shifts it to the right and a decrease in the money supply shifts it to the left.

Suppose the economy is in the grip of recession and therefore the government adopts the expansionary monetary policy to lift the economy out of recession, thus it takes measures to increase in money supply in the economy. The increase in money supply, being the state of liquidity preference or demand for money remaining unchanged will lead to a fall in the rate of interest. At lower interest rate more loans and advances would be taken and more investments would be done, which will cause aggregate demand to increase and there will be a rise in income.

With an increase in money supply, the LM curve will shift to the right (LM₁ to LM₂) and the economy will move from equilibrium point E to equilibrium point D and rate of interest will fall from r₁ to r₂ and income will rise from Y₁ to Y₂.

Thus the IS-LM model shows the expansion in money supply, lower interest rate and rise in income.