IS-LM-FX Model and Stabilization Policy Suppose the fiscal authority of an economy implements expansionary policy. Specifically, the government introduces a lump-sum tax cut. Suppose also that this country has a credible fixed exchange rate regime and, following the tax cut, central bank uses monetary policy to maintain the peg.
a. Consider the graphical illustration of the IS-LM-FX model and answer the following questions comparing the initial equilibrium before any change was implemented to the equilibrium that prevails after all the policy changes are implemented.
- What happens to the consumer spending? - Why? Explain.
- What happens to the investment spending? Why? Explain.
- What happens to the trade balance? Why? Explain.
b. Assume, instead, that the country has floating exchange rates. Suppose that following the tax cut, the central bank decides to pursue an output stabilization policy. Comparing the initial equilibrium before any change was implemented to the equilibrium that prevails after all the policy changes are implemented: - What happens to the consumer spending? - Why? Explain.
- What happens to the investment spending? Why? Explain.
What happens to the trade balance? Why? Explain.