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

Monetary Disturbance 
Under flexible exchange rate system, an increase in money 
stock leads to an increase in income and a depreciation in the 
exchange rate. 
The economy is at the initial point E
 
 
 
 
 
 
Figure 10.3: Effects of an increase in the Money Stock 
 
A monetary expansion shifts the LM schedule to LM'. A point 
E' the goods and money markets clear, but home interest rate is 
below the world level. Therefore capital will tend to flow out; the 
balance of payments goes into deficit, and the exchange rate 
depreciation. The depreciation means that we become more 
competitive. Net exports rise, and therefore the IS curve shifts out 
and to the right. The process continues until we reach point E''. 
Interest rates are again at the world level, and the depreciation has 
led to a higher level of income. Monetary policy thus works by 
increasing net exports. 
Suppose the nominal quantity of money is increased. Prices 
are given. So the real money stock (M/P) increases. There is now 
i
Output
BP
0
0
Y
Interest
rate
LM
IS
Y
E
LM
E
E

---

available a larger real money stock than before. The LM curve 
shifts to the right (from LM to LM'). To restore equilibrium interest 
rate must fall and income level must rise. 
Now we must find out whether E' represents an equilibrium 
point. At E' both money market and goods markets are in 
equilibrium at the initial exchange rate but it is clear that the 
domestic interest rate (i) has fallen below the world interest rate (i
f
). 
This will generate capital outflows which will bring about exchange 
rate depreciation. This in turn will make the domestic goods more 
competitive and the foreign demand for the country‘s goods will 
increase. So the IS curve will shift to the right. 
As the arrows indicate, depreciation of the exchange rate 
continues until the relative price of domestic goods has fallen 
enough to raise demand and output to the level indicated by E''. At 
this point the country finds itself at equilibrium both in the goods 
market and money market at the rate of interest that is compatible 
with the world rate of interest. 
The inference is that under flexible exchange rate system with 
perfect capital mobility a monetary expansion leads to an increase 
in output and exchange rate depreciation. 
One way of thinking about this result with P fixed an increase 
in M increases 
M
P
. The demand for real balance is equal to L (i, Y). 
Since i cannot differ from the world rate of interest, Y has to rise 
to equate the demand for money to the supply. The exchange 
depreciation raises net exports and that increase in net exports, in 
turn sustains the higher level of output and employment. This also 
implies the proposition that monetary expansion improves the 
current account through the exchange rate depreciation. 
The point to note is that under the fixed exchange system 
the monetary authority cannot control the money supply whereas 
under a flexible exchange system it can.