ECO403 GDB Solution

“Consider IS curve and LM curve in an open economy as explained in a Mundell Flemming model. By having expansionary fiscal policy, there is an increase in government purchase and the IS curve shifts towards right. There is no change in LM curve and it remains vertical. Due to the shift of IS curve, the interest rate and income level remains same but the exchange rate varies”.

Required:

Keeping in view of open economy in the above scenario, if the government want to use expansionary fiscal policy to increase the income level then it cannot do that, why?

Solution:

If the govt. want to use expansionary fiscal policy to increase the income level then it cannot do that, because there is no change in the interest rate it is given and the LM is vertical LM curve, if use expansionary fiscal policy only the exchange rate become high and the income level remains fixed