In an open economy with fixed exchange rates, the central bank adjusts the money supply to maintain the fixed exchange rate. This changes the dynamics of the IS-LM model.

Here are the steps to show the effects of a domestic fiscal expansion on domestic output and domestic interest rate:

1. Draw the initial IS-LM diagram: Draw the IS curve and the LM curve on a graph where the vertical axis represents the interest rate and the horizontal axis represents the output. The point where the IS curve intersects the LM curve is the initial equilibrium point (E0), which corresponds to the initial interest rate (i0) and the initial output (Y0).

2. Fiscal expansion: A domestic fiscal expansion, such as an increase in government spending or a decrease in taxes, shifts the IS curve to the right from IS1 to IS2. This is because fiscal expansion increases aggregate demand, leading to an increase in output at each interest rate.

3. Initial response: Without central bank intervention, the economy would move to a new equilibrium point (E1) where the new IS curve (IS2) intersects the original LM curve. This corresponds to a higher interest rate (i1) and a higher output (Y1).

4. Central bank intervention: To maintain the fixed exchange rate, the central bank increases the money supply, which shifts the LM curve to the right from LM1 to LM2. The economy moves to a new equilibrium point (E2) where the new IS curve (IS2) intersects the new LM curve (LM2). This corresponds to the original interest rate (i0) and a higher output (Y2).

5. Effects on domestic output and interest rate: The fiscal expansion and the subsequent central bank intervention lead to an increase in domestic output but no change in the domestic interest rate. The increase in output is due to the increase in aggregate demand caused by the fiscal expansion. The interest rate remains unchanged because the central bank adjusts the money supply to offset the upward pressure on the interest rate caused by the fiscal expansion.

In conclusion, a domestic fiscal expansion in an open economy with fixed exchange rates leads to an increase in domestic output but no change in the domestic interest rate.

Question

In an open economy with fixed exchange rates, the central bank adjusts the money supply to maintain the fixed exchange rate. This changes the dynamics of the IS-LM model.

Here are the steps to show the effects of a domestic fiscal expansion on domestic output and domestic interest rate:

1. Draw the initial IS-LM diagram: Draw the IS curve and the LM curve on a graph where the vertical axis represents the interest rate and the horizontal axis represents the output. The point where the IS curve intersects the LM curve is the initial equilibrium point (E0), which corresponds to the initial interest rate (i0) and the initial output (Y0).

2. Fiscal expansion: A domestic fiscal expansion, such as an increase in government spending or a decrease in taxes, shifts the IS curve to the right from IS1 to IS2. This is because fiscal expansion increases aggregate demand, leading to an increase in output at each interest rate.

3. Initial response: Without central bank intervention, the economy would move to a new equilibrium point (E1) where the new IS curve (IS2) intersects the original LM curve. This corresponds to a higher interest rate (i1) and a higher output (Y1).

4. Central bank intervention: To maintain the fixed exchange rate, the central bank increases the money supply, which shifts the LM curve to the right from LM1 to LM2. The economy moves to a new equilibrium point (E2) where the new IS curve (IS2) intersects the new LM curve (LM2). This corresponds to the original interest rate (i0) and a higher output (Y2).

5. Effects on domestic output and interest rate: The fiscal expansion and the subsequent central bank intervention lead to an increase in domestic output but no change in the domestic interest rate. The increase in output is due to the increase in aggregate demand caused by the fiscal expansion. The interest rate remains unchanged because the central bank adjusts the money supply to offset the upward pressure on the interest rate caused by the fiscal expansion.

In conclusion, a domestic fiscal expansion in an open economy with fixed exchange rates leads to an increase in domestic output but no change in the domestic interest rate.

Knowee AI · Accepted Answer