Question

Hi
I've just done an exam and a big question was show the new equilibrium output of an effect of a fall in world income. It asked to show using
A) fixed exchange rate
B) flexible exchange rate
I've drawn 2 diagrams. For the fixed exchange rate I talked about the drop in world income and the IS schedule shifting to the left. This meant an incipitent capital outflow and bop deficit. So to prevent depreciation the central bank buys currency on the foreign exchange market. As a result of the reduction in the money supply the LM shifts left. The new equilibrium point being y', r'. However I'm confused about the flexible diagram. Using the flexible exchange rate I drew the diagram showing the IS schedule moving back to the original equilibrium. There is thus crowding out effect. The flexible exchange rate being ineffective. I can show an image if needed not the diagrams i drew. Please can someone let me know if these digrms we're correct asap. Thanks so much

Answer 1

Answer on Question #45312, Economics, Macroeconomics

Figure 2. Small Country Response to Big Country Real Shocks: Flexible Exchange Rate

As we can see from the figure above, under flexible exchange rate the decrease in world income will cause IS curve shift to the left, so both output and real interest rate will decrease. And then in the long run the LM curve will shift to the right, so the level of the output will move back, but the real interest rate will decrease again.

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