Answer to Question #121478 in Macroeconomics for Sahim Samran

Question

Can someone please explain what will be effect of an expansionary fiscal policy on output and price in the short and long run, under fixed vs floating exchange rate regime and perfect capital mobility? What IS-LM and AD-SRAS-LRAS graphs will be used??

Answer 1

The case of perfect capital mobility.

Suppose the state increases state. expenses, then the IS curve is shifted to the right

and the equilibrium goes to point 2, at this point income increases ⇒ demand for

money ⇒ r will increase, which leads to a significant inflow of capital. If the economy

could stay at point 2, then a higher interest rate would lead to infinitely

a large influx of capital. In these conditions, there would be no limit to the amount of foreign currency that the Central Bank would have to buy in exchange for domestic currency.

Ultimately, he would have exhausted all stocks of domestic assets.

State growth expenses in the following way affects the balance of payments :

1. r ↑ ⇒ KA ↑ ⇒ BP> 0,

2. Y ↑ ⇒ Xn ↓ ⇒ BP <0.

In this case, with ideal capital mobility, the growth factor r will be

dominate (the inflow of assets caused by the excess of the domestic rate over the world), and

therefore, at point 2, the balance of payments will be> 0.

Balance of payments surplus means excess supply of foreign

currency, which requires intervention from the Central Bank. Central bank

buys an excess of foreign currency, which leads to an increase in reserves and increase

the amount of money in the economy and the shift of the LM curve to the right. Note that the new equilibrium

will be achieved only when the LM curve moves so much that the internal rate

percent will again be equal to the world, i.e. equilibrium will go to point 3.

Comparing the new equilibrium with the initial one, we note that fiscal policy

proved to be very effective: output changed by the full amount of Keynesian

multiplier of autonomous expenses, while in a closed economy the output

changed less. The reason for the high efficiency of fiscal policy lies in

fixed interest rate. In a closed economy, fiscal expansion led to

interest rate growth and crowding out investments, at a constant rate the effect

crowding out investment is missing.