IEU - Lecture 9 - Open Macro with fixed ER

IEU - Lecture 9 - Open Macro with fixed ER - Izmir...

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Izmir University of Economics ECON 306 INTERNATIONAL ECONOMICS Lecture 9 Internal and External Balance with  Fixed Exchange Rates
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Impact of an external shock under fixed ER      i                                 Y 0                 BP     i 0 LM Given the equilibrium, if foreign income increases exports will  increase. IS
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     i                                 Y 0            i 0 LM IS The increase in exports will shift the BP curve to the right because any given level of  income can now be associated with a lower level of interest rate and still have BoP  equilibrium. Impact of an external shock under fixed ER     BP
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     i                                 Y 0            i 0 The increase in exports will also shift the IS curve to the right. Impact of an external shock under fixed ER LM     BP IS
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     i                                 Y 0         i 0 To defend fixed ER the central bank must purchase the surplus  foreign currency and increase money supply which shifts the LM  curve to the right. Impact of an external shock under fixed ER LM     BP IS
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     i                                 Y 0   Y 1          i 0 An increase in government spending (G ) or a decrease in taxes (T ) shifts the IS  curve to the right, putting upward pressure on domestic income and interest rate. The effect of expansionary fiscal policy – Complete capital immobility LM     BP IS
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     i     i 0 As the economy expands, imports and demand for foreign currency increase. To maintain  the ER the central bank sells foreign currency (buys domestic currency) which reduces  the money supply which shifts the LM curve leftward. 
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