CHAPTER12The Open Economy RevisitedQuestions For Review1

CHAPTER

12

The Open Economy Revisited

Questions for Review
1. In the Mundell–Fleming model, an increase in taxes shifts the IS* curve to the left. If the exchange rate floats freely, then the LM* curve is unaffected. As shown in Figure
12–1, the exchange rate falls while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase.

e

LM*

Exchange rate

Figure 12–1

A

B
IS2*

IS1*
Y

Income, output

119

Answers to Textbook Questions and Problems

Now suppose there are fixed exchange rates. When the IS* curve shifts to the left in Figure 12–2, the money supply has to fall to keep the exchange rate constant, shifting the LM* curve from LM*1 to LM*2. As shown in the figure, output falls while the exchange rate remains fixed.
Net exports can only change if the exchange rate changes or the net exports schedule shifts. Neither occurs here, so net exports do not change.

Exchange rate

e

LM*2

B

e

Figure 12–2

LM*1

A

Fixed exchange rate
IS1*

IS2*
Y2

Y

Y1
Income, output

We conclude that in an open economy, fiscal policy is effective at influencing output under fixed exchange rates but ineffective under floating exchange rates.
2. In the Mundell–Fleming model with floating exchange rates, a reduction in the money supply reduces real balances M/P, causing the LM* curve to shift to the left. As shown in Figure 12–3, this leads to a new equilibrium with lower income and a higher exchange rate. The increase in the exchange rate reduces the trade balance.

e

Exchange rate

120

*

LM2

Figure 12–3

*

LM1

B

A
IS*
Y2
Income, output

Y1

Y

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121

If exchange rates are fixed, then the upward pressure on the exchange rate forces the Fed to sell dollars and buy foreign exchange. This increases the money supply M and shifts the LM* curve back to the right until it reaches LM*1 again, as shown in
Figure 12–4.

Exchange rate

e

e

*

LM1

Fixed exchange rate

Figure 12–4

A

IS*
Y
Income, output

In equilibrium, income, the exchange rate, and the trade balance are unchanged.
We conclude that in an open economy, monetary policy is effective at influencing output under floating exchange rates but impossible under fixed exchange rates.
3. In the Mundell–Fleming model under floating exchange rates, removing a quota on imported cars shifts the net exports schedule inward, as shown in Figure 12–5. As in the figure, for any given exchange rate, such as e, net exports fall. This is because it now becomes possible for Americans to buy more Toyotas, Volkswagens, and other foreign cars than they could when there was a quota.

Exchange rate

e

Figure 12–5

e

NX1(e)
NX2(e)
NX2

NX1

Net exports

NX

Answers to Textbook Questions and Problems

This inward shift in the net-exports schedule causes the IS* schedule to shift inward as well, as shown in Figure 12–6. e LM *

Exchange rate

Figure 12–6

e1

A

e2

B
IS1*
IS2*
Y
Income, output

Y

The exchange rate falls while income remains unchanged. The trade balance is also unchanged. We know this since
NX (e) = Y – C(Y – T) – I(r) – G.
Removing the quota has no effect on Y, C, I, or G, so it also has no effect on the trade balance. The decline in net exports caused by the removal of the quota is exactly offset by the increase in net exports caused by the decline in the value of the exchange rate.
If there are fixed exchange rates, then the shift in the IS* curve puts downward pressure on the exchange rate, as above. In order to keep the exchange rate fixed, the
Fed is forced to buy dollars and sell foreign exchange. This shifts the LM* curve to the left, as shown in Figure 12–7.

Exchange rate

122

e

LM2*

LM1*

e

B

A

Figure 12–7

e
*
IS1
*

IS2

Y2

Y1

Y

Income, output

In equilibrium, income is lower and the exchange rate is unchanged. The trade balance falls; we know this because net exports are lower at any level of the exchange rate.

Chapter 12

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123

4. The following table lists some of the advantages and disadvantages of floating versus fixed exchange rates.
Table 12–1
Floating Exchange Rates
Advantages:

Disadvantages:

Allows monetary policy to pursue goals other than just exchange-rate stabilization, for example, the stability of prices and employment.
Exchange-rate uncertainty is higher, and this might make international trade more difficult.

Fixed Exchange Rates
Advantages:

Disadvantages:

Makes international trade easier by reducing exchange rate uncertainty.
It disciplines the monetary authority, preventing excessive growth in M. As a monetary rule, it is easy to implement.
Monetary policy cannot be used to pursue policy goals other than maintaining the exchange rate.
As a way to discipline the monetary authority, it may lead to greater instability in income and employment.

5. The impossible trinity states that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. In other words, you can only have two of the three. If you want free capital flows and an independent monetary policy, then you cannot also peg the exchange rate. If you want a fixed exchange rate and free capital flows, then you cannot have independent monetary policy. If you want to have independent monetary policy and a fixed exchange rate, then you need to restrict capital flows.

Problems and Applications
1. The following three equations describe the Mundell–Fleming model:
Y = C(Y – T) + I(r) + G + NX(e).
(IS)
M/P = L(r, Y).
(LM)
* r =r .
In addition, we assume that the price level is fixed in the short run, both at home and abroad. This means that the nominal exchange rate e equals the real exchange rate .
∋

a.

If consumers decide to spend less and save more, then the IS* curve shifts to the left. Figure 12–8 shows the case of floating exchange rates. Since the money supply does not adjust, the LM * curve does not shift. Since the LM * curve is unchanged, output Y is also unchanged. The exchange rate falls (depreciates), which causes an increase in the trade balance equal to the fall in consumption.

Answers to Textbook Questions and Problems

e

LM *
Figure 12–8

A

e1

B

e2

IS1*
IS2*

Y

Y1
Income, output

Figure 12–9 shows the case of fixed exchange rates. The IS* curve shifts to the left, but the exchange rate cannot fall. Instead, output falls. Since the exchange rate does not change, we know that the trade balance does not change either. e

Exchange rate

Exchange rate

124

e

LM2*

LM1*

B

A

Figure 12–9

*

IS2
Y2

Y1

*

IS1

Y

Income, output

In essence, the fall in desired spending puts downward pressure on the interest rate and, hence, on the exchange rate. If there are fixed exchange rates, then the central bank buys the domestic currency that investors seek to exchange, and provides foreign currency, shifting LM* to the left. As a result, the exchange rate does not change, so the trade balance does not change. Hence, there is nothing to offset the fall in consumption, and output falls.

Aggregate Demand in the Open Economy

Chapter 12

If some consumers decide they prefer stylish Toyotas to Fords and Chryslers, then the net-exports schedule, shown in Figure 12–10, shifts to the left. That is, at any level of the exchange rate, net exports are lower than they were before. e Exchange rate

Figure 12–10

NX1
NX2
NX
Net exports

This shifts the IS* curve to the left as well, as shown in Figure 12–11 for the case of floating exchange rates. Since the LM* curve is fixed, output does not change, while the exchange rate falls (depreciates).

Exchange rate

b.

125

e

LM*

e1

A

e2

B

Figure 12–11

*

IS1
*

IS2

Y
Income, output

The trade balance does not change either, despite the fall in the exchange rate.
We know this since NX = S – I, and both saving and investment remain unchanged. When consumers prefer to buy foreign cars, this will decrease net exports. The resulting decline in the value of the exchange rate will increase net exports and offset the decline, such that net exports remains unchanged
Figure 12–12 shows the case of fixed exchange rates. The leftward shift in the IS* curve puts downward pressure on the exchange rate. The central bank buys dollars and sells foreign exchange to keep e fixed: this reduces M and shifts the LM* curve to the left. As a result, output falls.

Answers to Textbook Questions and Problems

Exchange rate

e

*

e

*

LM2

LM1

B

A

Figure 12–12

*

*

IS1

IS2
Y2

Y

Y1

Income, output

c.

The trade balance falls, because the shift in the net exports schedule means that net exports are lower for any given level of the exchange rate.
The introduction of ATM machines reduces the demand for money. We know that equilibrium in the money market requires that the supply of real balances M/P must equal demand:
M/P = L(r*, Y).
A fall in money demand means that for unchanged income and interest rates, the right-hand side of this equation falls. Since M and P are both fixed, we know that the left-hand side of this equation cannot adjust to restore equilibrium. We also know that the interest rate is fixed at the level of the world interest rate. This means that income—the only variable that can adjust—must rise in order to increase the demand for money. That is, the LM * curve shifts to the right.
Intuitively, the decline in money demand will put downward pressure on the interest rate. This will cause capital outflow until balance is restored because in this model the interest rate will remain equal to the world interest rate. As capital flows out of the economy, the exchange rate will fall. This will increase net exports and output.
Figure 12–13 shows the case with floating exchange rates. Income rises, the exchange rate falls (depreciates), and the trade balance rises. e Exchange rate

126

*

LM1

Figure 12–13

*

LM2

A

e1

B

e2

IS*

Y1

Y2

Income, output

Y

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127

Figure 12–14 shows the case of fixed exchange rates. The LM* schedule shifts to the right; as before, this tends to push domestic interest rates down and cause the currency to depreciate. However, the central bank buys dollars and sells foreign currency in order to keep the exchange rate from falling. This reduces the money supply and shifts the LM* schedule back to the left. The LM* curve continues to shift back until the original equilibrium is restored.

Exchange rate

e

Figure 12–14

LM*

A

e

IS*
Y1

Y

Income, output

In the end, income, the exchange rate, and the trade balance are unchanged.
2. The economy is in recession, at point A in Figure 12–15. To increase income, the central bank should increase the money supply, thereby shifting the LM* curve to the right. If only that happened, the economy would move to point B, with a depreciated exchange rate that would stimulate exports and raise the trade balance. To keep the exchange rate from depreciating and the trade balance from rising, the fiscal authorities should cut taxes or increase government spending. That would shift the IS* curve to the right, so that the economy would move to point C. Under the assumption in the chapter that net exports depend only on the exchange rate, this would keep the trade

Exchange rate

e

e1

*

LM1

A

*

LM2

Figure 12–15

C

*

IS2

B
*

IS1

Y
Income, output

Answers to Textbook Questions and Problems

balance from changing. The increase in output and income would, instead, reflect an increase in domestic demand. (Note that without the monetary expansion, a fiscal expansion by itself would lead to a higher exchange rate—so the increase in domestic demand would be offset by a reduction in the trade balance.
3. a.
The Mundell–Fleming model takes the world interest rate r* as an exogenous variable. However, there is no reason to expect the world interest rate to be constant. In the closed-economy model of Chapter 3, the equilibrium of saving and investment determines the real interest rate. In an open economy in the long run, the world real interest rate is the rate that equilibrates world saving and world investment demand. Anything that reduces world saving or increases world investment demand increases the world interest rate. In addition, in the short run with fixed prices, anything that increases the worldwide demand for goods or reduces the worldwide supply of money causes the world interest rate to rise.
b.
Figure 12–16 shows the effect of an increase in the world interest rate under floating exchange rates. Both the IS* and the LM* curves shift. The IS* curve shifts to the left, because the higher interest rate causes investment I(r*) to fall. The LM* curve shifts to the right because the higher interest rate reduces money demand.
Since the supply of real balances M/P is fixed, the higher interest rate leads to an excess supply of real balances. To restore equilibrium in the money market, income must rise; this increases the demand for money until there is no longer an excess supply. Intuitively, when the world interest rate rises, capital outflow will increase as the interest rate in the small country adjusts to the new higher level of the world interest rate. The increase in capital outflow causes the exchange rate to fall, causing net exports and hence output to increase, which increases money demand. e

*

Figure 12–16

*

LM2

LM1
A

e1
Exchange rate

128

*

IS1

B

e2

*

IS2
Y1

Y2

Y

Income, output

We see from the figure that output rises and the exchange rate falls (depreciates).
Hence, the trade balance increases.

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c.

129

Figure 12–17 shows the effect of an increase in the world interest rate if exchange rates are fixed. Both the IS* and LM* curves shift. As in part (b), the IS* curve shifts to the left since the higher interest rate causes investment demand to fall.
The LM* schedule, however, shifts to the left instead of to the right. This is because the downward pressure on the exchange rate causes the central bank to buy dollars and sell foreign exchange. This reduces the supply of money M and shifts the LM* schedule to the left. The LM* curve must shift all the way back to
LM*2 in the figure, where the fixed-exchange-rate line crosses the new IS* curve.

Exchange rate

e

e

Figure 12–17
*

*

LM2

LM1

B

A

*

IS1
*

IS2
Y2

Y1

Y

Income, output

In equilibrium, output falls while the exchange rate remains unchanged. Since the exchange rate does not change, neither does the trade balance.
4. a.

A depreciation of the currency makes American goods more competitive. This is because a depreciation means that the same price in dollars translates into fewer units of foreign currency. That is, in terms of foreign currency, American goods become cheaper so that foreigners buy more of them. For example, suppose the exchange rate between yen and dollars falls from 200 yen/dollar to 100 yen/dollar.
If an American can of tennis balls costs $2.50, its price in yen falls from 500 yen to
250 yen. This fall in price increases the quantity of American-made tennis balls demanded in Japan. That is, American tennis balls are more competitive.

Answers to Textbook Questions and Problems

b.

Consider first the case of floating exchange rates. We know that the position of the
LM* curve determines output. Hence, we know that we want to keep the money supply fixed. As shown in Figure 12–18A, we want to use fiscal policy to shift the
IS* curve to the left to cause the exchange rate to fall (depreciate). We can do this by reducing government spending or increasing taxes.
Figure 12–18
A. Floating exchange rate

e

LM*

e1

A

e2

B. Fixed exchange rates

Exchange rate

Exchange rate

130

*

IS1

B

e

LM*

e1

A

e2

C

B

*

*
IS2

*

IS2
Y1
Income,
Income, output output Y

Y
Income, output

IS1

Y

Now suppose that the exchange rate is fixed at some level. If we want to increase competitiveness, we need to reduce the exchange rate; that is, we need to fix it at a lower level. The first step is to devalue the dollar, fixing the exchange rate at the desired lower level. This increases net exports and tends to increase output, as shown in Figure 12–18B. We can offset this rise in output with contractionary fiscal policy that shifts the IS* curve to the left, as shown in the figure.

Chapter 12

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131

5. In the text, we assumed that net exports depend only on the exchange rate. This is analogous to the usual story in microeconomics in which the demand for any good (in this case, net exports) depends on the price of that good. The “price” of net exports is the exchange rate. However, we also expect that the demand for any good depends on income, and this may be true here as well: as income rises, we want to buy more of all goods, both domestic and imported. Hence, as income rises, imports increase, so net exports fall. Thus, we can write net exports as a function of both the exchange rate and income:
NX = NX(e, Y).
Figure 12–19 shows the net exports schedule as a function of the exchange rate. As before, the net exports schedule is downward sloping, so an increase in the exchange rate reduces net exports. We have drawn this schedule for a given level of income. If income increases from Y1 to Y2, the net exports schedule shifts inward from NX(Y1) to
NX(Y2).
e

Exchange rate

Figure 12–19

NX (Y1)
NX (Y2)
NX
Net exports

Figure 12–20 shows the effect of a fiscal expansion under floating exchange rates.
The fiscal expansion (an increase in government expenditure or a cut in taxes) shifts the IS* schedule to the right. But with floating exchange rates, if the LM* curve does not change, neither does income. Since income does not change, the net-exports schedule remains at its original level NX(Y1).

Exchange rate

a.

e

LM*

e2

B

e1

A

Figure 12–20

IS2*
IS1*

Y1
Income,
output
Income, output

Answers to Textbook Questions and Problems

b.

The final result is that income does not change, and the exchange rate appreciates from e1 to e2. Net exports fall because of the appreciation of the currency.
Thus, our answer is the same as that given in Table 12–1.
Figure 12–21 shows the effect of a fiscal expansion under fixed exchange rates.
The fiscal expansion shifts the IS* curve to the right, from IS*1 to IS*2. As in part
(a), for unchanged real balances, this tends to push the exchange rate up. To prevent this appreciation, however, the central bank intervenes in currency markets, selling dollars and buying foreign exchange. This increases the money supply and shifts the LM* curve to the right, from LM*1 to LM*2. e Exchange rate

132

*

*

LM 1

LM 2

A

B

e

Figure 12–21

IS2*
IS1*

Y1

Y2

Y

Income, output

Output rises while the exchange rate remains fixed. Despite the unchanged exchange rate, the higher level of income reduces net exports because the netexports schedule shifts inward.
Thus, our answer differs from the answer in Table 12–1 only in that under fixed exchange rates, a fiscal expansion reduces the trade balance.
6. We want to consider the effects of a tax cut when the LM* curve depends on disposable income instead of income:
M/P = L[r, Y – T].

Aggregate Demand in the Open Economy

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133

A tax cut now shifts both the IS* and the LM* curves. Figure 12–22 shows the case of floating exchange rates. The IS* curve shifts to the right, from IS*1 to IS*2. The
LM* curve shifts to the left, however, from LM*1 to LM*2. e LM2*

Exchange rate

e2

LM1*

Figure 12–22

B

IS2*

A

e1

IS1*

Y2

Y

Y1
Income, output

We know that real balances M/P are fixed in the short run, while the interest rate is fixed at the level of the world interest rate r*. Disposable income is the only variable that can adjust to bring the money market into equilibrium: hence, the LM* equation determines the level of disposable income. If taxes T fall, then income Y must also fall to keep disposable income fixed.
In Figure 12–22, we move from an original equilibrium at point A to a new equilibrium at point B. Income falls by the amount of the tax cut, and the exchange rate appreciates. If there are fixed exchange rates, the IS* curve still shifts to the right; but the initial shift in the LM* curve no longer matters. That is, the upward pressure on the exchange rate causes the central bank to sell dollars and buy foreign exchange; this increases the money supply and shifts the LM* curve to the right, as shown in Figure
12–23.

Exchange rate

e

e

LM1*

LM2*

Figure 12–23

B
A

IS2*
IS1*
Y1

Y2
Income, output

Y

Answers to Textbook Questions and Problems

The new equilibrium, at point B, is at the intersection of the new IS* curve, IS*2, and the horizontal line at the level of the fixed exchange rate. There is no difference between this case and the standard case where money demand depends on income.
7. Since people demand money balances in order to buy goods and services, it makes sense to think that the price level that is relevant is the price level of the goods and services they buy. This includes both domestic and foreign goods. But the dollar price of foreign goods depends on the exchange rate. For example, if the dollar rises from 100 yen/dollar to 150 yen/dollar, then a Japanese good that costs 300 yen falls in price from
$3 to $2. Hence, we can write the condition for equilibrium in the money market as
M/P = L(r, Y), where a.

b.

P = λPd + (1 – λ)Pf /e.
A higher exchange rate makes foreign goods cheaper. To the extent that people consume foreign goods (a fraction 1 – λ), this lowers the price level P that is relevant for the money market. This lower price level increases the supply of real balances M/P. To keep the money market in equilibrium, we require income to rise to increase money demand as well.
Hence, the LM* curve is upward sloping.
In the standard Mundell–Fleming model, expansionary fiscal policy has no effect on output under floating exchange rates. As shown in Figure 12–24, this is no longer true here. A cut in taxes or an increase in government spending shifts the
IS* curve to the right, from IS*1 to IS*2. Since the LM* curve is upward sloping, the result is an increase in output. e Exchange rate

134

LM*

e2

Figure 12–24

B

A

e1

IS2*
IS1*
Y1

Y2

Income, output

Y

Aggregate Demand in the Open Economy

Chapter 12

c.

135

The increase in the risk premium raises the interest rate for this country, lowering money demand at any given exchange rate and thereby shifting the LM* curve to the right. Intuitively, if real-money balances are fixed, then real-money demand must remain fixed. The decline in money demand caused by the increase in the interest rate must be offset by an increase in money demand caused by an increase in income. The reduction in money demand caused by the increase in the interest rate leads to a higher level of income for any given money supply. The higher interest rate also reduces investment spending at any given exchange rate, shifting the IS* curve to the left. As shown in Figure 12-25, the exchange rate falls and output may either rise or fall depending on the size of the shifts.
Figure 12–25 e LM*
LM*1

Exchange rate

LM*2
A
e1

IS1*

B
IS2*
Y1

Y

Income, output

If money demand is not very sensitive to the interest rate and investment is very sensitive to the interest rate, then IS* will shift by more than LM* and output will decline. Compared to the traditional Mundell-Fleming model, where LM* is vertical, output can fall here, whereas it does not fall in the traditional model but instead always rises. This model gives the more realistic result that both the exchange rate and output are likely to decline when the risk premium rises.
8. a.

b.

c.

California is a small open economy, and we assume that it can print dollar bills.
Its exchange rate, however, is fixed with the rest of the United States: one dollar can be exchanged for one dollar.
In the Mundell–Fleming model with fixed exchange rates, California cannot use monetary policy to affect output, because this policy is already used to control the exchange rate. Hence, if California wishes to stimulate employment, it should use fiscal policy.
In the short run, the import prohibition shifts the IS* curve out. This increases demand for Californian goods and puts upward pressure on the exchange rate. To counteract this, the Californian money supply increases, so the LM* curve shifts out as well. The new short-run equilibrium is at point K in Figures 12–26(A) and
(B).
Assuming that we started with the economy producing at its natural rate, the increase in demand for Californian goods tends to raise their prices. This rise in the price level lowers real money balances, shifting the short-run AS curve upward and the LM* curve inward. Eventually, the Californian economy ends up at point C, with no change in output or the trade balance, but with a higher real exchange rate relative to Washington.

Answers to Textbook Questions and Problems

A. The Mundell-Fleming Model

Figure 12–26

∋
LM*

Exchange rate

C

K

A

IS*
Y

Income, output

B. The Model of Aggregate Supply and Aggregate Demand

P
P2

Price level

136

P1

C

SRAS

A
K

AD2
AD1
Income, output

Y

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More Problems and Applications to Chapter 12
1. a.

Higher taxes shift the IS curve inward. To keep output unchanged, the central bank must increase the money supply, shifting the LM curve to the right. At the new equilibrium (point C in Figure 12–27), the interest rate is lower, the exchange rate has depreciated, and the trade balance has risen.

Figure 12–27

A. The IS–LM Model

r

r

LM2

A r1 r2

C

IS1
IS2

Income, output

CF(r)
Y

Net capital outflow

CF

C. The Market for Foreign Exchange

e

Exchange rate

Real interest rate

B. Net Capital Outflow

LM1

CF

e1

e2
NX(e)
NX1
NX2
Net exports

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Answers to Textbook Questions and Problems

b.

Restricting the import of foreign cars shifts the NX(e) schedule outward [see panel
(C)]. This has no effect on either the IS curve or the LM curve, however, because the CF schedule is unaffected. Hence, output doesn’t change and there is no need for any change in monetary policy. As shown in Figure 12–28, interest rates and the trade balance don’t change, but the exchange rate appreciates.

Figure 12–28
A. The IS-LM Model

r

B. Net Capital Outflow

r

Real interest rate

LM

IS
CF(r)
Y

CF

Net capital outflow

C. The Market for Foreign Exchange

e

Exchange rate

Income, output

CF

e2

e1
NX(e)2
NX(e)1
NX
Net exports

Chapter 12

b.
c.

d.

139

The CF curve becomes flatter, because a small change in the interest rate now has a larger effect on capital flows.
As argued in the text, a flatter CF curve makes the IS curve flatter, as well.
Figure 12–29 shows the effect of a shift in the LM curve for both a steep and a flat
IS curve. It is clear that the flatter the IS curve is, the less effect any change in the money supply has on interest rates. Hence, the Fed has less control over the interest rate when investors are more willing to substitute foreign and domestic assets. It is clear from Figure 12–29 that the flatter the IS curve is, the greater effect any change in the money supply has on output. Hence, the Fed has more control over output. LM1

LM2

Figure 12–29

r

Real interest rate

2. a.

Aggregate Demand in the Open Economy

Cflat
Csteep

ISflat

ISsteep
Income, output

Y

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Answers to Textbook Questions and Problems

3. a.

b.

No. It is impossible to raise investment without affecting income or the exchange rate just by using monetary and fiscal policies. Investment can only be increased through a lower interest rate. Regardless of what policy is used to lower the interest rate (e.g., expansionary monetary policy and contractionary fiscal policy), net foreign investment will increase, lowering the exchange rate.
Yes. Policymakers can raise investment without affecting income or the exchange rate with a combination of expansionary monetary policy and contractionary fiscal policy, and protection against imports can raise investment without affecting the other variables. Both the monetary expansion and the fiscal contraction would put downward pressure on interest rates and stimulate investment. It is necessary to combine these two policies so that their effects on income exactly offset each other.
The lower interest rates will, as in part (a), increase net capital outflow, which will put downward pressure on the exchange rate. The protectionist policies, however, shift the net-exports curve out; this puts countervailing upward pressure on the exchange rate and offsets the effect of the fall in interest rates. Figure 12–30 shows this combination of policies.

Figure 12–30
LM1
r

r
LM2

A

A

r1

r2

B

B

IS2
Y1, Y2

CF(r)

IS1
Y

CF1

Income, output

CF2

CF

Net capital outflow

e

e1, e2

CF1

CF2

A

B

NX(e)
CF

CF
Net exports

NX

c.

141

Aggregate Demand in the Open Economy

Chapter 12

Yes. Policymakers can raise investment without affecting income or the exchange rate through a home monetary expansion and fiscal contraction, combined with a lower foreign interest rate either through a foreign monetary expansion or fiscal contraction. The domestic policy lowers the interest rate, stimulating investment.
The foreign policy shifts the CF curve inward. Even with lower interest rates, the quantity of capital outflow would be unchanged and there would be no pressure on the exchange rate. This combination of policies is shown in Figure 12–31.

Figure 12–31
LM1
r

r
LM2

r1

r2

IS2
Y1, Y2
Income, output

CF (r)

IS1
Y

CF1, CF2

CF

Net capital outflow

e

CF1

e1, e2

NX(e)
NX1 NX2
’
Net exports

4. a.

NX

Figure 12–32 shows the effect of a fiscal contraction on a large open economy with a fixed exchange rate. The fiscal contraction shifts the IS curve to the left in panel

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Answers to Textbook Questions and Problems

(A), which puts downward pressure on the interest rate. This tends to increase net capital outflow and cause the exchange rate to depreciate [see panels (B) and (C)].
To avoid this, the central bank intervenes and buys dollars. This keeps the exchange rate from depreciating; it also shifts the LM curve to the left. The new equilibrium, at point C, has an unchanged interest rate and exchange rate, but lower output.
This effect is the same as in a small open economy.
Figure 12–32
A. The IS-LM Model

r

B. Net Capital Ouflow

r

LM2

C
A

IS1
CF
IS2
Income, output

Y

Net capital outflow

CF

C. The Market for Foreign Exchange

e

CF

Exchange rate

Real interest rate

LM1

NX(e)

Net exports

NX

b.

143

Aggregate Demand in the Open Economy

Chapter 12

A monetary expansion tends to shift the LM curve to the right, lowering the interest rate [panel (A) in Figure 12–33]. This tends to increase net capital outflow and cause the exchange rate to depreciate [see panels (B) and (C)]. To avoid this depreciation, the central bank must buy its currency and sell foreign exchange.
This reduces the money supply and shifts the LM curve back to its original position. As in the model of a small open economy, monetary policy is ineffectual under a fixed exchange rate.

Figure 12–33
A. The IS-LM Model

B. Net Capital Outflow

r

r
LM1

Real interest rate

LM2

IS
CF(r)
Y

Net capital outflow

CF

C. The Market for Foreign Exchange

e

CF

Exchange rate

Income, output

NX(e)

Net exports

NX