Question

using an IS-LM-FE diagram as an aid, show the effect on a small open economy of a permanent increase in the full-employment level of output. assume flexible exchange rates and assume that the domestic interest rate does not deviate from the foreign interest rate. explain what happens to output, the price level, net exports, the nominal exchange rate, and the real exchange rate. ( Please provide your answer in word format. not in your handwriting)

Answer 1

In the above case the assumption of domestic exchange rates not deviating from foriegn exchange rates signifies perfect capital mobility. This is because in case of any deviation from foriegn interest rate, capital will flow in or out of the currency at an infinite rate till the equilibrium between the 2 is reached again. Thus the BP curve in this situation is horizontal to the X axis and remains fixed.

Under a flexible exchange rate system, Where there is an expansion of output in the economy, the IS curve shifts to th right. This disturbs the simultaneous internal and external equilibrium. The internal equilibrium now takes place at E1 which is above the BP curve. This signifies a BOP surplus as the country experiences more capital inflows than what is required to maintai the BOP equilibrium at the domestic interest rate.

A surplus in the BOP causes the currency to appreciate and the real exchange rate appreciates and it's exports become relatively costier and imports relatively cheaper therefore net exports fall. This will in turn cause the IS curve to shif leftwards and restore the balance of payments at the original point E.

The output level finally