Answer to Question #221225 in Macroeconomics for YAKUBU SALCHI

Question

With the aid of diagrams, brieftly explain the effectiveness of fiscal and monetary policy under fixed exchange rate system with perfect capital mobility within the IS-LM-BOP framework.

Answer 1

When the interest rate increases, private investment decreases. When government expenditure increases it crowds out other private investment.If LM curve becomes more steeper, interest responsiveness for money demand ends up being less. This similarly increases government expenditure leading to a large crowd out effect.