Question

Consider the current macroeconomic environment in China. The government considers 8% GDP growth as its target growth rate. But currently, Chinese policymakers feel the country will have trouble reaching this goal. They would like to increase Chinese GDP, using either fiscal or monetary policy. In our class, we have looked at the IS-LM –BOP framework to explore the effects of such policies on an economy. Use this framework to analyze policy choices in China. In particular:

1. China has a fixed exchange rate, and assume there is perfect capital mobility.

1. What would expansionary fiscal policy do for China? Use the IS-LM-BOP framework to analyze the effects on GDP, interest rates, and other indicators. Be sure to both draw the IS-LM-BOP AND explain these effects on Y, i, P and other important indicators.

2. What would expansionary monetary policy do for China? Use the IS-LM-BOP framework to analyze the effects on GDP, interest rates, and other indicators. Be sure to both draw the IS-LM-BOP AND explain these effects. Include the effects on Y, i, P and other important indicators.

Answer 1

Before analyzing which policy China needs to adopt to reach target growth rate, let us analyze the IS_LM_BoP framework first to understand the policy effect,

In an open economy, when there is perfect capital mobility with fixed exchange rate, domestic and foreign interest rate is equal initially. If expansionary fiscal policy is taken by Chinese government, then, the IS schedule shifts towards right as shown in figure 1. Initial equilibrium E*, is where IS and LM intersects. The new equilibrium is E^/, when IS₁ intersects the initial LM curve. Domestic interest rate rises to r₁, which is higher than foreign interest rate r_f. Hence, capital inflows in China increases. Central Bank of China intervenes to buy foreign exchange with Chinese currency Yuan. As a result, money supply increases in China shifting the LM curve to the right to be LM₁. Domestic interest rate eventually drops to r_f with the increase in money supply. New equilibrium is reached at E₁. drop in interest rate encourages domestic investment and thereby domestic output increases to Y₁. Domestic price level also increases as money supply increases due to having a direct relation between these two variables.

Figure 1

The effect of expansionary monetary policy is shown in figure 2

Figure 2

When expansionary monetary policy is taken under similar conditions of perfect capital mobility and fixed exchange rate, interest rate at domestic market falls below the foreign interest rate. LM curve shifts to the right. Therefore, a huge capital outflow is taken place from the Chinese economy. Investors sell off Chinese assets and sell Chinese currency. Central Bank of China intervenes into the market to stabilize and release foreign reserve assets. Central reduces money supply and eventually interest starts to rise unless restored again at r_f. Domestic output drops to Y* even after reaching at Y1 level. Monetary policy action remains completely ineffective.

Therefore, it can be seen that fiscal policy would be more effect for China in order to reach targeted in order to increase Chinese GDP.