Question

For each of the following situations, use the IS-LM-FX model to illustrate the effects of the shock. Please explain how you obtained your answer (do not just state the effect). For each case, state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I and TB. Assume the government allows the exchange rate to float and makes no policy response.

1. The money supply increases.
2. Government spending increases.
3. Foreign output decreases

In situations 2 and 3, how can the Central Bank use monetary policy (under a float exchange rate) to stabilize output?

Answer 1

under the flexible exchange rate the monetary policy is the most successful policy tool to stabilise the output. Monetary policy can be used to stabilize the output. If government wants to increase the output, it would buy foreign exchange to maintain the exchange rate. Money supply is raised that shift the LM curve to right and output rises.