Question

Use IS-LM-FX diagram to show in the product market, Money market, and the foreign market for home country. Label your graphs and use solid lines. Suppose the home country imposes a tariff that significantly reduces its imports. How would that affect the current account ? Using dashed lines for any shifted curves, show how this would affect interest rate, income and exchange rate? (10p)

a. Suppose that the above tariff was expected to be permanent. How would this affect future Exchange rate. Show how this would directly affect the IS-LM-FX ? What happens to current account? (5p)

b. Suppose instead that the exchange rate was fixed. Show how this would directly affect the IS-LM-FX ?

Answer 1

when there is imposition of tariff that will reduce imports and we have goot increased net exports as exports and imports gap increased. So there will be a increase in current account.

a) Now suppose tariff is imposed so this will decrease imports as imports will be costlier and this will increase expenditure in the home country which will shift the IS curve to the right as IS' and this would lead to have new equilibrium point which shows high level of interest rate and high level of GDP.

In the above graph 1 you can see IS curve is downward sloping and LM curve is upward sloping and a is the initial equilibrium point. when there is imposition of tariff that lead to low imports and have raise net exports gap and now expenditure in the economy increases that will shift IS curve to the IS' and we have new equilibrium point b, a new rate of interest r1 and Y1 we have and in graph 2 higher tariff lead to decraese in supply of currency that lead to shift in supply curve to the left. Hence we have new Exchange rate E1.

In foreign exchange market when there is imposition of tariff that lead to imports costlier and hence decrease in imports so this lead to decrease in supply of home currency . Therefore it lead to shift in supply curve to the left which will increase exchange rate.

Therefore, by imposing tariff rate of interest increase, income level increases and also that lead to higher exchange rate.

b) In case there is fixed exchange rate so this will be kept fixed by the government, so in case when there is a imposition of tariff that lead to higher exchange rate but to remain the same exchange rate government will decraese the interest rates.

In the above graph as there is fixed exchange rate so imposition of tariff would have lead to increase in exchnage rate by decraesing the supply but as government has to keep exchange rate fixed , government will decline rate of interest in the economy that lead to decline in demand so demand curve has shifted to the left. Therefore we have Fixed exchange rate which is E. As rate of interest dceraesed that elad to decline in IS curve so we have original rate of interest and output.

hence we have low rate of interest, low income , and fixed exchange rate.