Question

Using the IS/LM/BP model and assuming perfect capital mobility, explain:

a. how an increase in foreign income affects domestic output.

b. how a devaluation of the domestic currency affects domestic output.

Answer 1

ANSWER

a)

• Under perfect capital mobility, if foreign income rises, foreigners can import more products from international market. Therefore, export from domestic country increases as a result. Net export (X- M) rises. Equation of national income: Y = C+ I +G + NX .As the NX component rises, the national income rises as well. Effect on the domestic country can be seen under fixed and flexible exchange rate using IS/LM/BP model.

Under fixed exchange rate

Figure 1: effect under fixed exchange rate

When the NX rises, IS curve shifts towards right. Equilibrium point shifts to E₁. Any point above BP curve indicates that the domestic country is in trade surplus. Government intervention is required here as exchange rate is fixed. Government in this circumstance sells domestic currency and purchase foreign currency. LM curve shifts to the right as money supply increases in the economy. Domestic economy again reaches at the final equilibrium point at E₂ on the BP line. Expansionary fiscal policy is fully effective at the final equilibrium as national output rises to Y₂ bringing back the interest rate at the initial position. Therefore, as an effect of increase in foreign income under perfect capital mobility, domestic output increases.

Under flexible exchange rate

Figure 2: Effect under flexible exchange rate

• As IS curve shifts rightward due to increase in foreign income, balance of payment surplus is created in the domestic economy. Under flexible exchange rate, domestic currency appreciates. Appreciation of domestic currency increases relative price of export in foreign market and makes import cheaper. As a result, export decreases along with increase in import. NX starts to fall. Reduction in NX brings back the IS curve to its initial position. Output backs to Y₀. Therefore, under flexible exchange rate in the presence of perfect capital mobility, rise in foreign income initially increases output. However, final effect on output is nil. Output remains at the same level of initial equilibrium.

B)

• Appreciation of domestic currency hurts exports by making them less competitive, and encourage imports by making them cheaper. Higher import demand and lower export demand will reduce net exports, leading to lower aggregate demand and domestic output. At the same time, lower exports and higher imports increases demand for foreign currency and weakens domestic currency, causing a domestic currency depreciation, which further reduces net exports, leading to a lower domestic output.
• Appreciation of the domestic currency affects domestic output: It will affect the domectic output in many ways: 1) They are large budget and current account deficits.2) Limited foreign exchange reserves. 3) Reliance on bank financing and short-term international capital inflows. 4) Highly leveraged companies. It will lead to massive outflow of foreign capital. Central bank intervenes in the foreign exchange market to sell foreign exchange reserves.
• Government is rapidly losing its limited foreign exchange reserves.This generally accelerate the foreign capital outflows.