Question

One of the big differences between the functioning of a closed versus an open economy is the way fiscal policy affects an economy that fixes its exchange rate. Explain with the aid of charts what those differences are.

Answer 1

Consider the case of the close economy.

So, here “IS1” and “LM1” are the initial “IS” and “LM” curve, => the initial equilibrium is “E1”, => the equilibrium “r” and “Y” are given by “r1” and “Y1”. Now, the introduction of fiscal policy leads to shift of IS curve from “IS1” to “IS2”. So, the new equilibrium is “E2” the intersection of “IS2” and “LM1”, => the equilibrium “r” and “Y” both increases, => the new equilibrium “r=r2 > r1” and the new equilibrium income is “Y2 >Y1”.

Now, consider the case of “open economy case”.

So, initial equilibrium is “E1”, => the equilibrium interest rate and output is given by “r1” and “Y1” respectively, => at “E1” the home and the world interest rate both are at “r=r1”. Now, the introduction of “fiscal policy”, => the “IS” curve will shift to the right side to “IS2”, => the “Y” increases to “Y2” and “r” increases to “r2 > r1”, => home rate of return is more than the world rate of return, => massive capital inflow. Now, under “fixed exchange rate” massive capital inflow leads to excess supply in the foreign exchange market, => central bank of the home country have to purchase this excess supply of foreign exchange reserve to fixed the exchange rate, => the money supply increases in the economy. So, the LM curve shift to “LM2”, => the new equilibrium is given by “E3” where “r decreases to “r1” and “Y” further increases to “Y3”.

So, if we compare two case then we can see that “fiscal policy” is fully effective in “open economy case” compare to “close economy” case and the rate of interest will not change in the “open economy case” compare to “close economy”.