Answer to Question #289891 in Macroeconomics for REE

Question

(a)  An open economy with flexible exchange rates. While UIP stand for the uncovered interest parity condition.

(1)  In an IS-LM-UIP diagram, show the effect of a decrease in foreign output, Y*, on domestic output. Explain.

(6 Marks)

(2)  Discuss the effects of foreign fiscal policy expansion on foreign output, Y*, and on the foreign interest rate, i*? 

Answer 1

(A)

(1), (2)

The equilibrium of the money sector is reflected by the LM line (L - liquidity - liquidity and M - money - money).

The balance of the real sector is reflected by the IS line (I - Investments - investments and S - savings - savings).

The balance of the external sector is shown by the BP line (B - balance of payments - payment balance

Under a floating exchange rate, imports and exports also depend on the exchange rate IM(Y, E) and X(E). The money supply is considered unchanged and controlled by the state.

Equilibrium in all sectors of the economy can be achieved through separate or simultaneous use of state economic policy instruments - budget spending, regulation of the money supply and the exchange rate.

The LM line reflects the dependence of income on the interest rate and always has a positive slope. An increase in the interest rate reduces the speculative demand for money, as a result, the supply of money for transactions increases, which can only happen with an increasing level of income.

The IS line shows that when the interest rate falls, investment increases. As a result, the level of income will rise, which will allow for an increasing level of imports and savings and an equilibrium in the real sector of the economy. The IS line always has a negative slope, and the closer it is to the vertical, the greater its slope, the higher the marginal propensity to save or the less sensitive the volume of investment to changes in the interest rate. A smaller slope of the IS line corresponds to a lower marginal propensity to save and reflects the sensitivity of investments to changes in the interest rate. To neutralize even an insignificant decrease in the interest rate, a significant increase in income is required for the real sector of the economy to remain in equilibrium.

The BP line reflects the relationship between the national and international economies. Its movement depends on such parameters of the international economy as the dynamics of the exchange rate, the regime of international capital movement. VR always has a positive angle of inclination. The higher the income, and hence the higher the imports, the higher the interest rate must be to ensure the inflow of foreign short-term capital to finance it.

With a floating exchange rate in the country, the devaluation of the currency will lead to an increase in exports and a decrease in imports.

(2)

An increase in government spending financed by loans (with an increase in the state budget deficit) shifts the IS curve from IS0 to IS1, (figure), raising the interest rate to rl. The resulting capital inflow will lead to an appreciation of the real exchange rate. Demand for domestically produced goods will fall as imports become cheaper and exports more expensive, i.e. there is a loss of competitiveness. The IS curve will shift to the left back to the original IS0 curve as exports fall. The reason the economy moves back to its original equilibrium point is that as long as the domestic interest rate is higher than the world rate, capital outflows will continue and the exchange rate will rise. This process can only stop when the internal rate of interest is equal to r* again. The mechanism that ensures the reduction of the interest rate is the reduction of aggregate demand. Conclusion: fiscal policy is completely ineffective when exchange rates float freely and capital is mobile.