W3P6 - Open Economy ISLM Fiscal Policy

Question 1

Explain the effects of an increase in government spending if exchange rates are FLEXIBLE

Answer 1

When exchange rates are flexible, fiscal policy is ineffective. The increase in government spending will shift the IS schedule to the right. This will increase the domestic interest rate
and will lead to a domestic interest rate above the foreign interest rate (i>i*). Since the exchange rate is flexible, the domestic currency is appreciating. The appreciation will now reduce net exports as exports are
decreasing and imports are increasing. This will shift the IS schedule back to its initial position. Since exchange rates are allowed to fluctuate, there is no need for the Central Bank to intervene.

Question 2

Explain the effects of an increase in government spending if exchange rates are FIXED

Answer 2

When exchange rates are fixed, fiscal policy is effective. The increase in government spending will shift the IS
schedule to the right. This would increase the domestic interest rate and would lead to a domestic interest rate above the foreign interest
rate (i>i*). When exchange rates are fixed, this is not possible as we would see an
appreciation 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 to the right, this is done by the Central Bank by increasing the money supply and hence decreasing the interest rate.