3. 1) There should be perfect capital mobility
b/w two countries
2) And initially the economy is at BOP
equilibrium.
3) Also initially domestic interest rate is
equable to foreign interest rate.
4. Increase in government
spending
IS shifts right to IS1
Domestic interest rate increases,
massive capital inflow(as
people invest more inside US)
To invest in US, people convert
more to dollar (dollar demand
increase, hence exchange rate
fall(dollar appreciation)
Fall in exchange rate, domestic
goods expensive, exports
reduce, output falls, to initial
level
5. Increase in monetary supply
LM shifts right to LM1
Domestic interest rate
decreases, massive capital
outflow(as people invest more
outside US)
To invest outside US, people
convert more to others (dollar
demand decrease, hence
exchange rate rise(dollar
depreciates)
rise in exchange rate, foreign
goods expensive, exports rises,
output rises back to initial level
of interest rate
6. Govt. expenditure rise
IS shifts right to IS1
Domestic rate >foreign
interest rate
Capital inflows
Central bank to maintain
fixed exchange rate,
increases money supply
LM right to LM1
Interest rate back to old
level, exchange rate
maintained, output further
increases
7. Monetary supply increases
LM shifts to right
Domestic interest< foreign
interest , capital outflow
To maintain exchange rate
fixed, central bank reduces
money supply
LM1 back to LM, at
previous equilibrium point
e0
8. Flexible exchange rate
Fiscal policy is ineffective and Monetary
policy is effective
Fixed exchange rate
monetary is ineffective and Fiscal policy is
effective
