Question

Part III: IS-LM-BP (Mundell-Fleming Model, or open economy IS-LM)

Assume a country is a small open economy under floating exchange rate system and perfect capital mobility.
Q1: Assume Y < Y*, money and goods markets are in equilibrium. BP = 0 (since floating system). Draw the graph depicting this situation.
Q2: Suggest how to decrease the output gap.

Answer 1

Under a floating system, the exchange rate (E) adjusts automatically to maintain balance of payments (BP) equilibrium. Initially, we're told BP = 0, signifying equilibrium.

The IS curve represents equilibrium in the goods market, where planned investment (I) equals planned saving (S) at different interest rates (i).

The LM curve represents equilibrium in the money market, where the money supply (Ms) equals money demand (Md) at different interest rates.

The BP curve is horizontal at BP = 0, reflecting equilibrium in the balance of payments under a floating exchange rate system.

The equilibrium point (E) lies where all three curves intersect, indicating simultaneous equilibrium in the goods, money, and external sectors.