Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

Output
i
BP
0
IS
0
Y
Interest
rate
LM
E
IS
f
i
E

---

expansion) do not change output. They simply lead to currency 
appreciation and thereby to an offsetting change in net exports. 
To begin with, it means an excess demand for that country‘s 
goods. That is, at the initial interest rate, exchange rate and output 
level the aggregate demand for goods exceeds the available 
supply. This indicates that a higher level or output is required for 
restoring equilibrium in the goods market. Therefore the IS curve 
shifts to the right from IS to IS'. The new intersection point must be 
E', at which the goods market and money market clear, at this point 
the level of output has risen and consequently the interest rate also 
has moved up (on account of a rise in demand for money caused 
by increase in income). 
But E' is not a equilibrium point because BOP is not in 
equilibrium. In fact the economy will not move to E' at all, because 
any tendency to move in that direction will be checked by an 
appreciation in the exchange rate and the economy will crawl back 
to the initial equilibrium point at E. The adjustment process that will 
be initiated by an in
crease in world demand for the country‘s goods 
is as follows:
To start with there is a tendency for output and income to 
increase. The increase in the demand for money induced by these 
changes will raise the domestic interest rate, which will as a result 
cease to be in alignment with this world interest rate. The resulting 
capital inflows will bring about an appreciation of the country‘s 
exchange rate and a consequent increase in imports and a 
decrease in exports. So the demand shifts away from domestic 
goods; the IS curve moves back to the original position (i.e., IS). 
It may be asked how far the appreciation of the exchange 
rate will proceed? This will continue so long as the domestic 
interest rate (i) exceeds the world interest rate (i
f
) 
– until the IS 
schedule moves back to it original position. 
The inference is that under conditions of perfect capital 
mobility an expansion is exports have no lasting effect on 
equilibrium output. 
Fiscal Policy: 
Fiscal expansion is similar in its impact on the level of output 
to an increase in exports, because it too raises the level of 
aggregate demand. All the attendant consequences associated 
with an increase in exports follow: increase in interest rate, 
currency appreciation, fall in exports and increase in imports. In this 
case, complete ‗crowding out‘ takes place, but for a different 
reason. It is not because of a reduction in investment resulting from 

---

an increase in interest rate but because exchange appreciation 
reduce net exports. 
This situation may be contrasted with the effectiveness of 
fiscal expansion in raising equilibrium output under fixed exchange 
rate system. 
To repeat, under flexible exchange rate system with perfect 
capital mobility, real disturbances to demand do not affect 
equilibrium output.