QUESTION 3With fixed exchange rate system, the policy makers can only rely on fiscal policy tools to influence output. Explain. as

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Fixed Exchange RateFiscal Policy

•Initial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rf•G ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to B•BP is perfect interest inelastic. BP is fully determined by CA. We focus on the effect brought by ↑ in y•y ↑, M ↑ (M > X), CA < 0 , BP < 0 (point B, IB < EB)•BP < 0, DDfe↑, CB sells foreign currency, R ↓, Ms ↓, LM ↓(LM0 shifts left to LM1), y ↓(y1 to y0), r ↑ (r1 to r2), from point B to C•Overall: y remains unchanged (y0)r ↑ (r0 to r2)BP = 0 (point C), IB=EB•Conclusion: Under fixed exchange rate system, fiscal policy is not effective when BP is vertical (no capital mobility)Fixed Exchange Rate Fiscal Policy Case 1: (vertical BP)-No capital mobilityLM1IS0LM0IS1BP0r0r10ACY0Y1rYBr2

LM1IS0IS1BP0r0r10Y0Y1rYA•Initial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rf•G ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to B•BP is less interest elastic. BP is mainly determined by CA. •y ↑, M↑, CA < 0•r↑, rd > rf, KA > 0 •BP < 0, DDfe↑, CB sells foreign currency, R ↓, Ms ↓, LM ↓(LM0 shifts left to LM1), y ↓(y1 to y2), r ↑ (r1 to r2), from point B to C•Overall: y ↑ (y0 to y2)r ↑ (r0 to r2)BP = 0 (point C), IB=EB•Conclusion: Under fixed exchange rate system, fiscal policy is less effectivewhen BP is steeper than LM(low capital mobility)BCFixed Exchange Rate Fiscal Policy Case 2: (BP steeper than LM)-Low Capital MobilityY2LM0r2

LM1IS0IS1BP0r0r20Y0Y2rYA•Initial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rf•G ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to B•BP is highly interest elastic. BP is mainly determined by KA. •y ↑, M↑, CA < 0•r↑, rd > rf, KA > 0 •BP > 0, DDfe↓, CB buys foreign currency, R ↑, Ms ↑, LM ↑(LM0 shifts right to LM1), y ↑(y1 to y2), r ↓ (r1 to r2), from point B to C•Overall: y ↑ (y0 to y2)r ↑ (r0 to r2)BP = 0 (point C), IB=EB•Conclusion: Under fixed exchange rate system, fiscal policy is fairly effectivewhen BP is flatter than LM (high capital mobility)BCFixed Exchange Rate Fiscal Policy Case 3: (BP flatter than LM)-High Capital MobilityY1LM0r1

LM1IS0LM0IS1BP0r0r10Y0Y1rYA•Initial: At point A, IB = EB (Intersection IS-LM and BP), BP=0, rd = rf•G ↑, IS ↑ (IS0 shifts right to IS1), y↑ (yo to y1), r ↑(r0 to r1), from point A to B•BP is perfect interest elastic. BP is fully determined by KA. We focus on the effect brought by ↑ in r•r↑, rd > rf, capital inflow ↑, KA > 0, BP > 0 (point B, IB > EB)•BP > 0, DDfe↓, CB buys foreign currency, R ↑, Ms ↑, LM ↑(LM0 shifts right to LM1), y ↑(y1 to y2), r ↓ (r1 to r0), from point B to C•Overall: y ↑ (y0 to y2)r remains unchanged (rd=rf)BP = 0 (point C), IB=EB•Conclusion: Under fixed exchange rate system, fiscal policy is very effectivewhen BP is horizontal (perfect capital mobility)BCFixed Exchange Rate Fiscal Policy Case 4: (horizontal BP)-Perfect capital mobilityY2

Fixed Exchange RateMonetary Policy

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