Question

Suppose you run the central bank in an open economy. What happens to the following variables of interest in response to the below events (analyze each event separately)?

I) The president cuts government spending to reduce the budget deficit

II) The president restricts the import of Chinese goods

Use the standard open economy IS-LM model (not the Fleming-Mundell model). Also, assume direct effects of shifts are larger than indirect effects.

a) IS – Direct Effect (increase / decrease / indeterminate / no change)?

b) IS – Exchange Rate Effect (increase / decrease / indeterminate / no change)?

c) LM (increase / decrease / indeterminate / no change)?

d) Interest rate (increase / decrease / indeterminate / no change)?

e) Exchange rate (increase / decrease / indeterminate / no change)?

f) Output (increase / decrease / indeterminate / no change)?

g) If the goal of the Central Bank is to stabilize income, the bank should change the money supply in which way (increase / decrease / no change)?

Answer 1

Solution:-

Given that

I. the president raises taxes to cut down the budget deficit

a.

IS direct effect: decrease because raising tax will reduce aggregate demand and IS curve shifts towards left

b.

IS exchange rate effect: there will be a reduction in the import demand hence the exchange rate will increase and we can expect a boost in the net export hence the exchange rate effect will increase.

c.

No change in LM because the tax will have no effect on money supply

d.

The interest rate will decrease as the IS curve shifts to the left

e.

Exchange rate will increase

f.

the output will decrease(IS curve shifts to the left)

g.

to stabilise income, the bank should increase the money supply then only aggregate demand will increase to the previous level.

II. the president restricts imports of Chinese goods

a.

IS direct effect: increase, because reducing Chinese import will increase the net export of the country and this will increase the aggregate demand of the country.

b.

IS exchange rate effect: Exchange rate will rise due to a rise in net exports hence export may decline in response to the increased exchange rate. hence the exchange rate effect may be intermediate

c.

No change in LM because the import restriction will have no effect on money supply

d.

The interest rate will increase as the IS curve shifts to the right

e.

Exchange rate will increase due to the rise in net export

f.

the output will increase(IS curve shifts to the right)

g.

to stabilise income, the bank should decrease the money supply then only aggregate demand will decline to the previous level.

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