International macroe.. - Free

8.1. A STATIC MUNDELL-FLEMING MODEL 235rLMr*acFFy 0(1)by 1(2)ISyFigure 8.4: Expansion of domestic credit shifts LM curve out. Incipientcapital outßow is offset by depreciation of domestic currency whichshifts the IS curve out.home currency ds =[(1− γ)/φδ]dm > 0. The expenditure switchingeffect of the depreciation increases expenditures on the home good andhas an expansionary effect on output dy =(1/φ)dm > 0.The situation is represented graphically in Figure 8.4 where theexpansion of domestic credit shifts the LM curve to the right. In theclosed economy, the home interest rate would fall but in the small openeconomy with perfect capital mobility, the result is an incipient capitaloutßow which causes the home currency to depreciate (s increases) andthe IS curve to shift to the right. The effectiveness of monetary policyis restored under ßexible exchange rates.Fiscal policy. Fiscal policy becomes ineffective as a stabilization toolunder ßexible exchange rates and perfect capital mobility. The situationis depicted in Figure 8.5. An expansion of government spending isrepresentedbyaninitialoutwardshiftintheIScurvewhichleadstoanincipient capital inßow and an appreciation of the home currency ds =−(1/δ)dg < 0. The resulting expenditure switch forces a subsequentinward shift of the IS curve. The contractionary effects of the inducedappreciation offsets the expansionary effect of the government spendingleaving output unchanged dy = 0. The model predicts an international