Question

Explain:
1.1. What is the international trilemma and elaborate in the case of US.
1.2. If LM curve is vertical,
A. What must happen in money market?
B. Will an expansionary fiscal policy effective, why or why not?

Answer 1

1. The international trilemma which consist of three impossible concepts include free capital mobility, fixed exchange rate system and independent monetary policy. A single economy cannot posses these three situations. This condition is defined as international trilemma or impossible trinity. This trilemma was occurred during the decision of international monetary policy. If a government impose fixed exchange rate and free capital mobility, they were need to change the interest rate according to the economic conditions. The monetary policy decisions cannot be take independently at this situation. The economy has free capital mobility and independent monetary authority will have to follow floating exchange rate. This will create depreciation and appreciation of the currencies. In case of US, there is free capital mobility and independent monetary policy with floating exchange rate system. Thus the economy will face appreciation and depreciation of currencies with respect to the changes in the economic activities. There was a volatility occurred in the exchange rate.

2. The vertical LM curve can be seen in long run, where the money supply is inelastic towards the money market or the policies of central bank.

a) The increase in money supply in the economy will shift the LM curve to right. This will leads to lowering of interest rate and cause rise in the level of output and overall production. The equilibrium in the money market was determined with respect to the change in interest rate according to the level of money supply. The changing money supply will make the interest rate volatile and total production will change according to this.

b) The expansionary fiscal policy under vertical LM cure was ineffective. The expansionary fiscal policy make a shift in IS curve and this will not make any change in the level of output because of this vertical supply curve. The LM curve is vertical because of that the money supply is determined and maintained by the central bank, which act as an exogenous sector.