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# solution_ps5 - International Economics: EC315 Lent term,...

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International Economics: EC315 Lent term, 2002 Solutions to Problem Set 5 Question 1: Use the IS-LM model to determine how a fall in the world interest rate will influence domestic output under fixed and floating exchange rate regimes. How does your answer depend on the degree of capital mobility? In all cases, a decrease in the world interest rate will initially trigger a capital inflow and therefore increase the demand for domestic currency. Clearly the magnitude of these capital inflows and of the increase in demand for domestic currency depends crucially on the degree of capital mobility: the greater the degree of capital mobility then the greater their magnitude. Note that with zero capital mobility there is no impact at all. The consequences of these changes on output depend on the exchange rate regime in operation. Recall the three key relationships derived from the building blocks of the Mundell-Fleming model described in your lecture notes: Open economy IS: Y = C(Y-T) + I(r) + G + CA(Y, e) (+) (-) (-) (+) Open economy LM: M/P = L(Y, r) (+) (-) Balance of Payments: BP = CA(Y, e) + K(r-r*) = 0 (-) (+) (+) (Note with Perfect Capital Mobility, r = r*) Flexible exchange rate regime: The capital inflows induced by the fall in the world interest rate trigger a balance of payments surplus. With flexible exchange rates the incipient surplus results in an appreciation of the exchange rate which lowers exports and raises imports thereby creating a trade balance deficit. This balances the BOP and results in a contraction of output. In general, the consequences are greater the greater the degree of capital mobility. This part of the exercise shows that even with a completely flexible exchange rate, the policies followed by trade partners matter for domestic income. Figure 1 depicts the effects of a fall in r* in the high capital mobility case under a floating exchange rate. Point A is the initial equilibrium. From the BP equation above it is clear that a fall in r* causes the BP schedule to shift down to BP’, the capital inflows giving rise to a balance of payments surplus. The ensuing exchange rate appreciation yields a current account deficit shifting the BP schedule from BP’ to BP’’ and the IS 1

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Y. Figure 1 : r* with a flexible exchange rate and high capital mobility r IS LM IS’ BP e A r* BP’’ e B BP’ Y Figure 2 depicts the effects under perfect capital mobility. A is one again the initial equilibrium. Here r = r* and so the BP schedule is infinitely elastic at r*. When r* falls to r* ‘the BP schedule shifts down accordingly. The ensuing exchange rate appreciation is much larger yielding a larger CA deficit and thus a greater contraction in Y. Figure 2
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## This note was uploaded on 10/06/2011 for the course FIN 426 taught by Professor Gregbauer during the Spring '11 term at Rochester.

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solution_ps5 - International Economics: EC315 Lent term,...

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