Question

Compare the effect on GDP of an adverse demand shock in the closed and open economy cases using graphs based on the open economy IS-MP model. Assume flexible rate.

Answer 1

An adverse demand shock, by lowering aggregate demand, will decrease output.

In a closed economy, lower output will shift the IS curve leftward, which will decrease exchange rate and decrease output. In an open economy, however, a decrease in exchange rate (depreciation of domestic currency) will increase export and decrease import, increasing net export in the economy which will increase aggregate demand and output. Therefore decrease in output caused by lower aggregate demand will be exactly offset by an increase in output caused by higher net exports, and in new equilibrium, exchange rate will be lower but output will remain unchanged.

In following graph, IS0* and LM0 are initial IS and LM curves in a closed economy. The LM0 curve is upward rising in accordance to the shape of LM curve in closed economy, though open-economy LM curve (LM*) is vertical. So, IS0* and LM0 are initial IS and LM curves in an open economy. Initial equilibrium is at point A where IS0* intersects LM0 and LM* with exchange rate e0 and output Y0. When output falls, IS0* shifts leftward to IS1*. In a closed economy model, IS1* intersects LM0 at point B with lower output Y1 (since exchange rate is irrelevant for closed economy, we cannot say that exchange rate is lower in this case). But in an open economy model, IS1* will intersect LM* at point C, so exchange rate will decrease from e0 to e1, which will increase output exactly by the amount of fall in output due to lower aggregate demand, therefore output will remain unchanged at Y0. In open economy, fiscal policy will be ineffective.