Question

For each of the following situations, use IS-LM-FX model to illustrate the effects of the shock. For each case, state the effect of the shock on the following variables (increase, decrease, no change or ambiguous): Y, I, E, C, I, TB. Assume that the government allows the exchange rate to float and makes no policy response.

Foreign income decreases?

Investors expect a depreciation of the home currency?

The Money supply increases.?

Government spending increases.?

Answer 1

a) Foreign income decreases

figure 1

The effect of foreign income decrease is depicted in figure 1. When foreign income decreases, IS shifts left from IS1 to IS2 and DR shifts down from DR1 to DR2. Because of this, Y decreases, i decreases, E increases, C decreases, I increases and TB increases.

b) Investors expect a depreciation of the home currency

figure 2

The effect of the expectation is depicted in figure 2. When Investors expect a depreciation of the Home currency, FR shifts to right from FR1 to FR2, IS shifts right form IS1 to IS2 and DR shifts up from DR1 to DR2. Because of this, Y increases, i increases, E increases, C increases, I decreases and TB increases.

c) The money supply increases

Figure 3

The effect of the money supply increase is depicted in figure 3. When money supply increases, LM shifts right from LM1 to LM2 and DR shifts down from DR1 to DR2. Because of this, Y increases, i decreases, E increases, C increases, I increases and TB increases.

d) Government spending increases

Figure 4

The effect of the Government spending increase is depicted in figure 4. When Government spending increases, IS shifts right from IS1 to IS2 and DR shifts up from DR1 to DR2. Because of this, Y increases, i increases, E decreases, C increases, I decreases and TB decreases.