Answer to Question #221460 in Macroeconomics for Nana K

Question

A. With the aid of a diagrams, briefly explain how interest elasticities and demand for money affect the slope of the IS and the LM curve. (2 marks)

B. 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

A.

As the transactions demand for real money balances is an increasing function of real income, the total demand for real money balances can be shown as a function of the real rate of interest that shifts to the right as real income is increased.

The LM curve is upward sloping because of shifts in the demand for real money balance function as the level of real output increases.

B.

Monetary policy

With a huge inflow of capital, foreign exchange rate of the domestic currency will rise, that is, the currency of the country that adopts a higher interest rate monetary policy will appreciate.

The figure above shows IS and LM curves as well as the horizontal line BP. The horizontal line BL=0 at domestic interest rate ,$i$ is equal to foreign interest rate $i_f$ shows that the country has neither deficit or surplus in its balance of payments, that is, balance of payments is in equilibrium.

Fiscal policy.

Fiscal policy is highly effective given perfect mobility of capital. A government can use fiscal policy to rise the level of national income and employment. The diagram below shows the analysis that the commitment to maintain a fixed exchange rate makes the changes in money supply endogenous.

Determination of foreign exchange rate is shown in panel (b) where initially demand curve DD and supply curve SS of US dollars determine exchange rate equal to number of rupees per US dollar. When as a result of expansion in money supply, LM curve shifts to the right to the new position and consequently domestic rate of interest falls to $i_1$ , there will be large capital outflows.