Why is it that the LM curve in a small open economy is vertical and LM carve in large upward sloping?
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IS- LM curves watch
- Thread Starter
- 10-10-2012 05:09
- 14-10-2012 11:52
A vertical ISLM curve means that fiscal policy is ineffective at altering output.
Start by thinking of output as C + I + G + NX. An expansionary fiscal policy will increase output through raising G. However as you increase the demand for money this will raise the interest rate that brings the money markets (supply and demand for money) into equilibrium. The higher interest rate will mean a higher exchange rate which will decrease NX, which acts to counter the increase in output caused by raising G. In a small open economy this exchange rate effect will be stronger, as NX will be a larger proportion of output. If you take this to the extreme then the effect of decreasing NX will counter the effect of raising G so the effect on output is 0.
Basically it is saying fiscal policy just crowds out net exports because any expansion of fiscal policy will lead to a reduction of net exports through raising the interest rate, hence the exchange rate, which will increase imports and decrease exports.