Question

With reference to the IS-L-BP analysis of a small economy, answer the following questions and provide the required explanation and diagrams.

1. Assuming a country with perfect capital mobility and a flexible exchange rate, examine the effect that an expansionary monetary policy has for the domestic economy.
2. How might the outcome of an expansionary monetary policy differ if the exchange rate is fixed?

Answer 1

i) Perfect capital mobility and a flexible exchange rate

An expansionary monetary policy shifts the LM curve to LM’. As a result the equilibrium move to E₁ from point E₀. Since the exchange rates are flexible, the balance of payments deficit depreciates the domestic currency resulting in an increase net exports which shifts the IS curve to the right to IS’. The equilibrium is now at the point E_2. Production has increased.

LM LM

ii) Expansionary monetary policy and fixed exchange rate

An expansionary monetary policy shifts the LM curve to LM’ and the point of equilibrium moves from point E₀ to E₁. As it is below the BP curve, the economy has a balance of payments deficit. As there is fixed exchange rates, the government will sell foreign currency and purchase domestic currency. This will reduce the supply of money shifting the LM’ curve to its original position.

LM