Unformatted text preview: * We label these IS* and LM* to remind us that we are holding the interest rate constant at r*. The equilibrium of the economy is found where the IS* and the LM* curve intersect. This intersection determines the exchange rate and the level of income. The IS* curve slopes downward because a higher exchange rate lowers net exports and thus lowers aggregate income. The LM* curve is vertical because the exchange rate does not enter into the LM* equation. We can now use the IS* LM* diagram for the Mundell Fleming model to show how aggregate income Y and the Canadian dollar e respond to changes in policy.
Small open economy under floating exchange rates Under a system of floating, or flexible, exchange rates, the exchange rate is set by market forces and is allowed to fluctuate in response to changing economic conditions. The exchange rate e adjusts to achieve simultaneous equilibrium in the goods market and the money market. Three policies that can change the equilibrium: Fiscal policy: expansionary fiscal policy shifts IS* to the right, which causes the exchange rate to appreciate while income remains the same. In a closed economy IS LM model, a fiscal expansion raises income. In a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same level. The appreciation of the currency causes a drop in NX which exactly offsets the effects of the expansionary fiscal policy. To understand this, examine the equation M/P = L(r, Y) which describes the money market. Since M is fixed by the central bank, we are assuming prices are sticky, and r is fixed at r*, there is only one level of income that can satisfy the equation. Thus, when the government increases spending Page 40 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 or cuts taxes, the appreciation of the exchange rate and fall in net exports must be exactly large enough to offset fully the normal expansionary effect of the policy on income. Monetary policy: suppose the Bank of Canada increases the money supply. Since P is assumed to be fixed, this increases real balances and shifts LM* to the right, thus raising income and lowering the exchange rate. It raises income by putting pressure on the domestic interest rate,...
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 Fall '10
 Henriques
 Economics, Macroeconomics

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