With fixed exchange rate system the policy makers can

This preview shows page 12 - 21 out of 39 pages.

QUESTION 3With fixed exchange rate system, the policy makers can only rely on fiscal policy tools to influence output. Explain. as
Equations
Fixed Exchange RateFiscal Policy
Initial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rfG ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to BBP is perfect interest inelastic. BP is fully determined by CA. We focus on the effect brought by ↑ in yy ↑, M ↑ (M > X), CA < 0 , BP < 0 (point B, IB < EB)BP < 0, DDfe↑, CB sells foreign currency, R ↓, Ms ↓, LM ↓(LM0 shifts left to LM1), y ↓(y1 to y0), r ↑ (r1 to r2), from point B to COverall: y remains unchanged (y0)r ↑ (r0 to r2)BP = 0 (point C), IB=EBConclusion: Under fixed exchange rate system, fiscal policy is not effective when BP is vertical (no capital mobility)Fixed Exchange Rate Fiscal Policy Case 1: (vertical BP)-No capital mobilityLM1IS0LM0IS1BP0r0r10ACY0Y1rYBr2
LM1IS0IS1BP0r0r10Y0Y1rYAInitial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rfG ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to BBP is less interest elastic. BP is mainly determined by CA. y ↑, M↑, CA < 0r↑, rd > rf, KA > 0 BP < 0, DDfe↑, CB sells foreign currency, R ↓, Ms ↓, LM ↓(LM0 shifts left to LM1), y ↓(y1 to y2), r ↑ (r1 to r2), from point B to COverall: y ↑ (y0 to y2)r ↑ (r0 to r2)BP = 0 (point C), IB=EBConclusion: Under fixed exchange rate system, fiscal policy is less effectivewhen BP is steeper than LM(low capital mobility)BCFixed Exchange Rate Fiscal Policy Case 2: (BP steeper than LM)-Low Capital MobilityY2LM0r2
LM1IS0IS1BP0r0r20Y0Y2rYAInitial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rfG ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to BBP is highly interest elastic. BP is mainly determined by KA. y ↑, M↑, CA < 0r↑, rd > rf, KA > 0 BP > 0, DDfe↓, CB buys foreign currency, R ↑, Ms ↑, LM ↑(LM0 shifts right to LM1), y ↑(y1 to y2), r ↓ (r1 to r2), from point B to COverall: y ↑ (y0 to y2)r ↑ (r0 to r2)BP = 0 (point C), IB=EBConclusion: Under fixed exchange rate system, fiscal policy is fairly effectivewhen BP is flatter than LM (high capital mobility)BCFixed Exchange Rate Fiscal Policy Case 3: (BP flatter than LM)-High Capital MobilityY1LM0r1
LM1IS0LM0IS1BP0r0r10Y0Y1rYAInitial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rfG ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to BBP is perfect interest elastic. BP is fully determined by KA. We focus on the effect brought by ↑ in rr↑, rd > rf, capital inflow ↑, KA > 0, BP > 0 (point B, IB > EB)BP > 0, DDfe↓, CB buys foreign currency, R ↑, Ms ↑, LM ↑(LM0 shifts right to LM1), y ↑(y1 to y2), r ↓ (r1 to r0), from point B to COverall: y ↑ (y0 to y2)r remains unchanged (rd=rf)BP = 0 (point C), IB=EBConclusion: Under fixed exchange rate system, fiscal policy is very effectivewhen BP is horizontal (perfect capital mobility)BCFixed Exchange Rate Fiscal Policy Case 4: (horizontal BP)-Perfect capital mobilityY2
Fixed Exchange RateMonetary Policy

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture