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Learning unit 7: The IS-LM model in an open economy
Question 1
1. What will happen to investment spending (I)? Give two reasons for this change.
Investment spending will increase. The first reason for this increase is that the expansionary
monetary policy lowers the domestic interest rate from i to i1, and since investment spending is a
negative function of the interest rate, a lower interest rate directly reduces the cost of borrowing and
increases investment (Blanchard et al., 2014, p. 414). The second reason is that the lower interest rate
leads to an increase in the level of output and income from Y to Y1. Because investment spending is
also a positive function of output, the higher level of economic activity further stimulates investment
as firms need to expand their production capacity to meet the increased demand (ECS2602, Study
Guide, p. 221).
Question 2
2. What happens with the nominal exchange rate? Give the reason for this change.
The nominal exchange rate will decrease, which represents a depreciation of the domestic currency.
This happens because a decrease in the domestic interest rate, relative to the foreign interest rate,
makes domestic bonds less attractive to financial investors. As a result, there is a capital outflow,
which increases the demand for foreign currency and reduces the demand for the domestic currency
in the foreign exchange market, leading to its depreciation (ECS2602, Study Guide, p. 232). This
relationship is shown by a downward movement along the interest parity relation curve, where a
lower interest rate corresponds to a lower exchange rate (ECS2602, Study Guide, p. 218).
Question 3
3. What happens to exports? Give the reason for this change.
Exports will increase. The reason for this is that the depreciation of the domestic currency, which
lowered the nominal exchange rate, makes domestic goods relatively cheaper for foreign buyers.
This price effect stimulates foreign demand for the country's goods, leading to a rise in the volume of
exports (ECS2602, Study Guide, p. 199).
Question 4
4. Why are imports indeterminate? Give two reasons.
Imports are indeterminate because there are two opposing forces at play. On the one hand, the
depreciation of the domestic currency makes foreign goods more expensive in terms of domestic
currency, which tends to decrease the quantity of imports (ECS2602, Study Guide, p. 199). On the
other hand, the expansionary monetary policy successfully increases the domestic level of output and
income, and since imports are a positive function of domestic income, this higher income leads to an
increase in the demand for all goods, including imports (ECS2602, Study Guide, p. 227). The net
effect on the total value of imports depends on which of these two effects is stronger.
Learning unit 7: The IS-LM model in an open economy
Question 1
1. What will happen to investment spending (I)? Give two reasons for this change.
Investment spending will increase. The first reason for this increase is that the expansionary
monetary policy lowers the domestic interest rate from i to i1, and since investment spending is a
negative function of the interest rate, a lower interest rate directly reduces the cost of borrowing and
increases investment (Blanchard et al., 2014, p. 414). The second reason is that the lower interest rate
leads to an increase in the level of output and income from Y to Y1. Because investment spending is
also a positive function of output, the higher level of economic activity further stimulates investment
as firms need to expand their production capacity to meet the increased demand (ECS2602, Study
Guide, p. 221).
Question 2
2. What happens with the nominal exchange rate? Give the reason for this change.
The nominal exchange rate will decrease, which represents a depreciation of the domestic currency.
This happens because a decrease in the domestic interest rate, relative to the foreign interest rate,
makes domestic bonds less attractive to financial investors. As a result, there is a capital outflow,
which increases the demand for foreign currency and reduces the demand for the domestic currency
in the foreign exchange market, leading to its depreciation (ECS2602, Study Guide, p. 232). This
relationship is shown by a downward movement along the interest parity relation curve, where a
lower interest rate corresponds to a lower exchange rate (ECS2602, Study Guide, p. 218).
Question 3
3. What happens to exports? Give the reason for this change.
Exports will increase. The reason for this is that the depreciation of the domestic currency, which
lowered the nominal exchange rate, makes domestic goods relatively cheaper for foreign buyers.
This price effect stimulates foreign demand for the country's goods, leading to a rise in the volume of
exports (ECS2602, Study Guide, p. 199).
Question 4
4. Why are imports indeterminate? Give two reasons.
Imports are indeterminate because there are two opposing forces at play. On the one hand, the
depreciation of the domestic currency makes foreign goods more expensive in terms of domestic
currency, which tends to decrease the quantity of imports (ECS2602, Study Guide, p. 199). On the
other hand, the expansionary monetary policy successfully increases the domestic level of output and
income, and since imports are a positive function of domestic income, this higher income leads to an
increase in the demand for all goods, including imports (ECS2602, Study Guide, p. 227). The net
effect on the total value of imports depends on which of these two effects is stronger.
