Question

21. (2pt) Analyze, graphically, the changes in equilibrium output, interest rate, and the nominal exchange rate when there is a contractionary monetary policy under a flexible exchange rate regime 2g. (pt) Analyze, graphically, the changes in equilibrium output, interest rate, and the nominal exchange rate when there is an expansionary fiscal policy under a flexible exchange rate regime. 2h. (3pt) Analyze, graphically, the changes in equilibrium output, interest rate, and the nominal exchange rate when there is a contractionary monetary policy under a fixed exchange rate regime 21. (3pt) Analyze, graphically, the changes in equilibrium output, interest rate, and the nominal exchange rate when there is an expansionary fiscal policy under a fixed exchange rate regime.

Answer 1

2f. Monetary policy is completely effective under flexible exchange rate system. In case of monetary contraction, LM shifts leftwards and interest rate rises. Due to this there will be inflow of capital which causes appreciation of domestic currency. With appreciation of domestic currency, domestic goods become relatively expensive and foreign goods become relatively cheap. As a result, Net exports decreases as Imports greater than exports and IS curve shifts leftwards. Therefore, Monetary policy is effective under flexible exchange rate system.

Interest rate, i LM 1 Balance of Payment is zero Y2Y1 Output, Y

2g. Under flexible exchange rate system, central bank will not intervene in foreign exchange market in order to influence exchange rate. The exchange rate must adjust so that demand and supply of foreign exchange becomes equal. Adjustment in exchange rate ensures that the sum of current account balance and capital account balance is zero.

Another implication of flexible exchange rate is that central bank can set money supply because there is no obligation to intervene. So, there is no longer any automatic link between Balance of Payment and Money supply. In flexible exchange rate system, Fiscal policy is ineffective because effect of fiscal expansion is crowded out by change in Net Exports.

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tm BPRO IS2 (y=C+I+G+ NX '15,CY=C+I+G,+NX) ding 1995 Nuo 1990

Due to fiscal expansion in the form of increase in government expenditure, IS curve shifts rightward but with rightward shift of IS curve interest rate increases which results in inflow of capital and surplus in Balance of Payment. Due to this domestic currency appreciates and it causes decline in net exports. Therefore, there is no change in output an interest rate.

2i. Fiscal policy is extremely effective under fixed exchange rate system. If there is fiscal expansion then IS curve shifts rightwards which causes increase in interest rate. Higher interest rate results into capital inflow and thereby surplus in Balance of Payment. Due to this there is pressure for currency appreciation. But to keep exchange rate fixed central bank will intervene by selling home money and receiving foreign money. This causes monetary expansion and LM curve shifts rightward. With rightward shift of LM curve interest rate returns back to initial level but the significant point is that with fiscal expansion output of economy has increase which indicates effectiveness of fiscal policy.

Pouch IS,C YPAD) Y Y Laval aged Y