SME502 Macroeconomic Management and Policy

Discussion 4 (Group A)

1. Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect a reduction in foreign output (Y*) will
have on the domestic economy. In your graphs, clearly label all curves and equilibria.

The open economy versions of the familiar IS and LM relations:

We first assume that before the reduction in Y*, the level of output, Y, was above potential.
If the decrease in Y* moves the output towards potential, but not below potential, the
central bank will not be worried that deflation might increase and will keep the interest rate
unchanged.

The economy is initially at point A. The reduction in foreign output Y* will cause a
reduction in exports (X) and net exports (NX). This causes the IS curve to shift to the left
from IS to IS’. The new equilibrium is at point A’ with lower level of output Y’. The LM
curve does not shift since the central bank does not change the policy rate, and thus the
exchange rate does not change.
Domestic interest rate, i

Domestic interest rate, i

A’ A LM A

IS
IS’

Y’ Y 𝐸ത 𝑒
Output, Y Exchange rate, E

1
 Now we assume that before the reduction in Y*, the level of output, Y, was close to potential
output, 𝒀𝒏 . If the decrease in Y* moves the output below potential, the central bank will
worry that the decrease in Y* might cause deflation, it is likely to respond by lowering the
interest rate i. The economy is initially at point A. The reduction in foreign output Y* will
cause a reduction in exports (X) and net exports (NX). This causes the IS curve to shift to the
left from IS to IS’. The new equilibrium is at point A’ with lower level of output Y’. When
the central bank reduces the interest rate, the LM curve shifts downward to LM’. Output will
decrease by less and eventually move back to the natural level 𝑌𝑛 ,

and the exchange rate will depreciate from E to E’’.

Domestic interest rate, i

Domestic interest rate, i

A
LM A’ A

LM’ A’’ A’’

IS
IS’

Y’ Y’’,Y
E’’ E
Output, Y

Exchange rate, E