Question

Although the American news most often covers accusations of China manipu- lating its currency to keep its exchange rate low and boost Net Exports, the same criticism was aimed at the United States in the years following the global nancial crisis. Part of the Fed's monetary policy during this time was to dramatically increase the supply of money through a program referred to as Quantitative Easing. Modeling the U.S. as a large open economy, answer the following:

a) How does the monetary expansion aect equilibrium in the IS/LM model in the short run? Explain all changes in the short run.

b) Given the change in the equilibrium real interest rate, what happens to Net Capital Out ows (Net Foreign Investment) in the short run? Explain why this change occurs.

c) Explain how the real exchange rate and Net Exports change due to the change in Net Capital Out ows in the short run.

d) What has happened to Output in the short run compared to its initial equilibrium? What components of GDP have driven the increase in short run Output? Would you classify

Answer 1

a) In the short run, monetary expansion shifts the LM curve to the right. Due to this, the interest rate falls and the output increases. This is shown in the graph below.

b) As the equilibrium interest rates have fallen, net capital outflow increases. This is because foreign investments are now relatively more profitable. (Mundell Fleming model)

c) Due to monetary expansion, the domestic interest rate (i) is now lesser than the foreign interest rate (i_f). As a result, there is an outflow of capital and hence a deficit in BOP account. The demand for the dollar in our country increases. Due to this, there will be a depreciation of our currency, and the exchange rate increases. It means domestic goods become relatively cheaper and foreign goods relatively expensive. Therefore net exports increase.

d) As we saw in part a), the short run output actually increases, as compared to its initial equilibrium. The increase in money supply targets private consumers and encourages private consumption. Also, the fall in interest rate also encourages investment activity in the economy.