# With fixed exchange rate system the policy makers can

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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
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