Macroeconomic policies in an open economy Frederick University 2013

Fixed exchange rate and full capital mobility Fiscal expansion i Y IS LM IS’ LM shifts rightwards until the reason for foreign exchange inflows is eliminated LM’ A new equilibrium is achieved at the same i, and higher Y Conclusion: under a fixed exchange rate and full capital mobility, Fiscal policy is effective i rises. Foreign currency inflows The Central Bank buys currency to support the fixed exchange rate MS increases

Fixed exchange rate and full capital mobility Monetary expansion i Y IS LM LM’ i falls Foreign currency outflows The Central Bank sells currency MS falls LM shifts leftwards Conclusion: under a fixed exchange rate and full capital mobility, Monetary policy is not effective

Fixed exchange rate and full capital immobility Fiscal expansion i Y IS LM IS’ LM’ The new equilibrium is achieved at the initial income level but at a higher interest rate Conclusion: under a fixed exchange rate and full capital immobility, Fiscal policy is ineffective Y increases. Imports (M) increase and the public needs more currency The Central Bank sells currency MS falls LM shifts leftwards until the reason for the change is eliminated

Fixed exchange rate and full capital immobility Monetary expansion i Y IS LM LM’ LM shifts leftwards Y rises M increase The Central Bank sells currency MS falls Conclusion: under a fixed exchange rate and full capital immobility, Monetary policy is ineffective

Floating exchange rate and full capital mobility Fiscal expansion i Y IS LM i rises and foreign capital inflows Foreign currency supply rises and local currency becomes more expensive Imports (M) increase and exports (X) fall IS shifts leftwards Conclusion: under a floating exchange rate and full capital mobility, Fiscal policy is ineffective

Floating exchange rate and full capital mobility Monetary expansion i Y IS LMLM’ IS’ i falls and currency outflows. Local currency becomes cheaper M fall and X increase IS shifts rightwards Conclusion: under a floating exchange rate and full capital mobility, Monetary policy is effective

Floating exchange rate and full capital immobility Fiscal expansion i Y IS LM IS’ IS’’ Income rises and M increase Demand for foreign currency increases Foreign currency becomes more expensive and M fall and X rise IS shifts rightwards Conclusion: under a floating exchange rate and full capital immobility, Fiscal expansion leads to greater income and higher interest rate

Floating exchange rate and full capital immobility Monetary expansion i Y IS LM LM’ IS’ Income rises and M increases The demand for currency rises Foreign currency becomes more expensive Exports increase and imports fall IS shifts rightwards Conclusion: under a floating exchange rate and full capital immobility, Monetary policy is effective