Consider a small open open economy operating a fixed exchange rate. Compare the
ID: 1191190 • Letter: C
Question
Consider a small open open economy operating a fixed exchange rate. Compare the effects on domestic real GDP of an increase in government spending under each of the following circumstances: a. Imperfect capital mobility with sterilized intervention. b. Imperfect capital mobility and unsterlized intervention. c. Perfect capital mobility. Consider a small open open economy operating a fixed exchange rate. Compare the effects on domestic real GDP of an increase in government spending under each of the following circumstances: a. Imperfect capital mobility with sterilized intervention. b. Imperfect capital mobility and unsterlized intervention. c. Perfect capital mobility. a. Imperfect capital mobility with sterilized intervention. b. Imperfect capital mobility and unsterlized intervention. c. Perfect capital mobility.Explanation / Answer
a) Increase in government spending under imperfect capital mobility with sterilized intervention .
A rise in G leads to shift of IS and AD curve rightwards.This leads to a rise in interest rates that creates pressure for currency appreciation.However with imperfect capital mobility the pressure for currency appreciation would not be large.However to maintain the level of current exchange rate central bank would have to buy foreign exchange and sell domestic currency.The extent of increase in domestic liquidity at this time depends upon the amount of capital mobility allowed.A near perfect mobility would involve a large increase in liquidity whereas a near 0 mobility requires much less intervention.However whatever is the case there would be an increase in domestic money supply which would create conditions for inflation in the economy.Earlier the rise in G lead to increase in real GDP.Now an increase in money supply would further increase GDP.However with sterilization the LM curve shifts back hence the effect of increased money supply on output is neutralised and equilibrium is maintained at the output level attained after increase in G.
2)Under imperfect mobility and unsterilized intervention GDP would increase by a larger amount as compared to case1 .This is because GDP increases due to rise in G.Also when domestic currency circulation increases due to central bank intervention LM curve shifts rightwards which further increases GDP.Thus GDP increase here is higher.
3) In this case increase in GDP is the highest.This is because due to perfect capital mobility pressure for currency appreciation is much higher as compared to above 2 cases.Thus the domestic currency sold would be highest.With unsterlised intervention this shifts LM cuve thus increasing GDP further.Thus increase in GDP would be highest under this.