Question

suppose that a nation has perfect capital mobility and a fixed exchange rate, a negatively sloped IS and positively sloped LM curve. currently the economy is in recession. Should the nation fiscal authority or its central bank take the lead in trying to raise real income? Explain your answer.

Answer 1

Since there is a fixed exchange rate, any step taken by the central bank alone would be ineffective as it would then have to reverse its policy decision in the event of any change in the exchange rate. Take, for example, the current case of a recession. Monetary expansion results in shifting the LM curve to the right. This reduces rate of interest, raises capital outflows resulting in currency depreciation. For preventing such depreciation, a reverse monetary contraction would be followed that nullifies the previous expansion in money supply. Hence central bank is ineffective in combating recession

However fiscal expansion in conjugation with monetary expansion is most effective. It shifts the IS up, raising the interest rate and reducing capital outflows. Currency appreciates. For preventing such appreciation, a monetary expansion would be followed that shifts the LM curve out. This reduces interest rate and allow the currency to reach its pegged value. Hence a policy mix of fiscal and monetary expansion works well in case of fixed exchange rate