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Effectiveness Of Fiscal Policy Under Both Fixed And Floating Exchange Rates Using Is Lm Bp Model

1117 words - 5 pages

Effectiveness of Fiscal Policy under Both Fixed and Floating Exchange Rates using IS-LM-BP Model
In order to examine the degree in which fiscal policy can be used effectively in this model, the variables that directly influence the outcomes of its use need to be identified. These are, exchange rate regime whether fixed of flexible that is in place and the degree that capital is mobile. The level of capital mobility is how challenging or simple it is for private individuals or firms to move funds across borders. Exchange rate regimes fall into two categories fixed and flexible, flexible exchange rate means that it is determine by supply and demand factors of said currency. In a fixed ...view middle of the document...

Point C is the equilibrium point reached with higher levels of interest rates and income.

Fiscal Expansionary Policy in a Floating Exchange Rate Regime with Complete Capital Immobility



In this example the IS curve responds to expansionary fiscal policy implementation by shifting to the right from IS1 to IS2 and the economy settling at point B at Y2 and r2. This leads to a balance of payments deficit as there is insufficient capital inflows this causes the domestic currency to depreciate. A depreciating currency allows the price of domestic goods to fall in foreign markets thus exports increase. The increase in net exports simultaneously shifts the IS curve to IS3 and strengthens the current account so the BP curve shifts right from BP1 to BP2, leaving the economy at point C.

Fiscal Expansionary Policy in a Floating Exchange Rate with Relatively Mobile Capital

From the outset of the expansionary fiscal policy the IS schedule shifts right from IS1 to IS2, as capital is mobile any small increase in interest rate leads to large capital inflows. These capital inflows offset the weakened current account deficit easily putting the balance of payments in surplus at point B. This surplus leads to an overall appreciation of the domestic currency due to the increased capital inflows. Simultaneously shifting the LM schedule to LM2 the BP curve to BP2 and the IS curve to again to IS3. The new equilibrium at C with a higher level of output and interest rate and overall appreciation of the domestic currency.

Fiscal Expansionary Policy in a Floating Exchange Rate Scheme with Perfectly Mobile Capital

The implementation of the fiscal development policy leads to the IS curve moving to the right from is1 to IS2 leaving the economy at point B. This would mean that there would be a balance of payment surplus as it is above the BP curve. The balance of payment surplus will result in an appreciation of the domestic currency, in turn this will lead to a fall in net exports due to the comparative strength of the domestic currency. The drop in net exports causes the IS curve to go back to its original position of IS1 and the economy returns to A.


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