Explain the IS-LM open economy model. Using the model, assuming a flexible exchange rate, examine the effect of a fall in government expenditure on output, the interest rate, the exchange rate and the level of exports.

A

An open economy is open to foreign trade of goods and services. An open economy means that there is a high demand for a country’s products abroad (exports) and a decrease in domestic demand for its products because of the imports. Thus, spending in an open economy is given by: C + I + G + NX, where net imports (NX) are the exports (X) minus imports (V). The effect of an open economy on the IS curve is caused by the exchange rate. The IS curve is determined by a combination of interest rate, i, and GDP, Y.

A decrease in government fiscal spending causes the IS curve to shift from IS0 to IS1. If the LM curve is not affected i.e. assuming no sudden change in fiscal policies, then the interest rates would increase leading to crowding-out effect. Also, planned investments may reduce and thus affect the economy. However, by changing monetary policies during fiscal spending cuts, the government can reduce the interest rates causing a shift of LM0 to LM1. Thus, reduced government spending will increase the value of the domestic currency as X (appreciates) will fall while V will increase causing a net decrease in NX.

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Academic.Tips. 2020. "Explain the IS-LM open economy model. Using the model, assuming a flexible exchange rate, examine the effect of a fall in government expenditure on output, the interest rate, the exchange rate and the level of exports." April 26, 2020. https://academic.tips/question/explain-the-is-lm-open-economy-model/.

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Academic.Tips. "Explain the IS-LM open economy model. Using the model, assuming a flexible exchange rate, examine the effect of a fall in government expenditure on output, the interest rate, the exchange rate and the level of exports." April 26, 2020. https://academic.tips/question/explain-the-is-lm-open-economy-model/.

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