Macroeconomic policies in an open economy

Frederick University

2013

Fixed exchange rate and full capital mobility

Fiscal expansion

i

Y

IS

LM

IS’

LM shifts rightwards until the reason for foreign exchange inflows is eliminated

LM’A new equilibrium is achieved at the same i,and higher Y

Conclusion: under a fixed exchange rate and full capital mobility,Fiscal policy is effective

i rises. Foreign currency inflowsThe Central Bank buys currency to support the fixed exchange rateMS increases

Fixed exchange rate and full capital mobility

Monetary expansion

i

Y

IS

LM

LM’

i fallsForeign currency outflowsThe Central Bank sells currencyMS falls

LM shifts leftwards

Conclusion: under a fixed exchange rate and full capital mobility,Monetary policy is not effective

Fixed exchange rate and full capital immobility

Fiscal expansion

i

Y

IS

LM

IS’

LM’The new equilibrium is achieved at the initial income level but at a higher interest rate

Conclusion: under a fixed exchange rate and full capital immobility,Fiscal policy is ineffective

Y increases. Imports (M) increase and the public needs more currencyThe Central Bank sells currencyMS falls

LM shifts leftwards until the reason for the change is eliminated

Fixed exchange rate and full capital immobility

Monetary expansion

i

Y

IS

LMLM’

LM shifts leftwards

Y risesM increaseThe Central Bank sells currencyMS falls

Conclusion: under a fixed exchange rate and full capital immobility,Monetary policy is ineffective

Floating exchange rate and full capital mobility

Fiscal expansion

i

Y

IS

LM

i rises and foreign capital inflowsForeign currency supply rises and local currency becomes more expensiveImports (M) increase and exports (X) fall

IS shifts leftwards

Conclusion: under a floating exchange rate and full capital mobility,Fiscal policy is ineffective

Floating exchange rate and full capital mobility

Monetary expansion

i

Y

IS

LM LM’

IS’

i falls and currency outflows.Local currency becomes cheaperM fall and X increase

IS shifts rightwards

Conclusion: under a floating exchange rate and full capital mobility,Monetary policy is effective

Floating exchange rate and full capital immobility

Fiscal expansion

i

Y

IS

LM

IS’

IS’’Income rises and M increaseDemand for foreign currency increasesForeign currency becomes more expensive and M fall and X rise

IS shifts rightwards

Conclusion: under a floating exchange rate and full capital immobility,Fiscal expansion leads to greater income and higher interest rate

Floating exchange rate and full capital immobility

Monetary expansion

i

Y

IS

LMLM’

IS’

Income rises and M increasesThe demand for currency risesForeign currency becomes more expensiveExports increase and imports fall

IS shifts rightwards

Conclusion: under a floating exchange rate and full capital immobility,Monetary policy is effective