Question

Does the dependence of net exports on the real
exchange rate make the IS curve steeper or flatter?

Answer 1

When the real exchange rate is high, the relative price of goods at home is higher than the relative price of goods in abroad. ... Thus, when the real exchange rate is high, net exports decrease as imports rise. Alternatively, when the real exchange rate is low, net exports increase as exports rise.

IS – curve model involves the determination of national income and rate of interest through joint equilibrium of goods market and money market.

Equality of planned expenditures and actual income/output gives IS – curve. Since in an open economy a part of increase in income is spent on imports rather than on domestically produced goods, IS curve of an open economy is steeper than that of a closed economy. This means that for a given reduction in interest rate, a smaller increase in output and income is required to restore equilibrium in the goods market.

Besides, IS curve of the open economy also includes net exports as a component of aggregate demand for goods. The real exchange rate of the national currency, which determines the prices of exports and imports and thereby determine net exports also affects the open economy IS curve.

Total expenditure on domestically produced output comes from four sources: household consumption (C), investments (I), government spending (G), and net exports (X - M). IS curve can be understand by below figure.

IS curve (Y) = C + I + G + (X - M)

If there is a trade deficit [(X - M) < 0] then domestic private saving is being supplemented by inflows of foreign saving and overseas economies are building up financial claims against the domestic economy.

from above figure In an open economy with fixed exchange rate and if there is dependence on the net exports , then the IS curve will be steeper and if the exchange rate is flexible the IS curve can be the flatter.

so we can say that ependence of net exports on the real exchange rate make the IS curve steeper.

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