W3P5 - Open Economy ISLM Monetary Policy

Question 1

Explain the effects of an INCREASE in the MONEY SUPPLY if exchange rates are FLEXIBLE

Answer 1

When exchange rates are flexible, monetary policy is effective. The increase in the money supply will shift the LM schedule to the right. This will lower domestic interest rates and will lead to a domestic interest rate below the foreign interest rate (i<i*). Since the exchange rate is flexible, the domestic currency is depreciating. The depreciation will now increase net exports i.e. exports increase and imports decrease. This will result in a right shift of the IS schedule. We are moving along the LM schedule and interest rates increase because of the higher output level. When domestic interest rates equal foreign interest rates, the exchange rate is stable i.e. not changing
anymore we are in equilibrium.

Question 2

Explain the effects of an INCREASE in the MONEY SUPPLY if exchange rates are FIXED

Answer 2

When exchange rates are fixed, monetary policy is ineffective. The increase in the money supply will shift the LM schedule to the right. This would lower the domestic interest rate and
would lead to a domestic interest rate below the foreign interest rate (i<i*). When exchange rates are fixed, this is not possible as we would see a depreciation of the currency. As fiscal policy is slow to react, the IS schedule will not be able to shift immediately. Hence the LM schedule has to shift back to its initial position, which will be achieved by contractionary monetary policy.

Question 3

When exchange rates are FLEXIBLE, what is monetary policy?

Answer 3

effective

Question 4

When exchange rates are FIXED, what is monetary policy?

Answer 4

INEFFECTVE