Question

Assuming perfect capital mobility and flexible exchange rates, explain the impact on the Irish economy of a decrease in interest rates in the U.S. In your answer, clearly indicate the effect on income, rate of interest, balance of payments. (Show your answer with the help of an IS-LM-BP diagram and explain the mechanisms. Consider Ireland a small open economy with flexible exchange rates. b) Are Monetary and Fiscal policies effective in the case of question (a)? Explain with graphs

Answer 1

Perfect capital mobility tells that BP will be horizontal at world interest rate.

After Decrease in World interest rate( US) ,BP( balance of payment) curve shift downward.

Now at initial equilibrium points, there is surplus of balance of payment.

Supply of BOP ,will appreciate currency, and lead to decline in met EXPORTS.

Decrease in net EXPORTS will shift IS curve to left and economy reach at new equilibrium.

At new equilibrium equilibrium gdp and interest rate is lower. BOP is in balance ( equilibrium is on BP curve).

In this scenario ( perfect capital mobility and flexible exchange rate). There is no impact of fiscal policy ,it creates a surplus in bop and thus lead to curreny appreciation and decline in net EXPORTS.

On other hand monetry policy is usefull to increase GDP.