Restrictive Trade Policy under Floating and Fixed Exchange Rate

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When Government imposes import quota or tariff to reduce import, exports will increase, imports will decrease and thus NX will increase.

When Government imposes import quota, NX will rise

NX curve shifts to the right to NX₂ (Fig. 18.13(a))

^..^. NX is a component of AD (Y = C + I + G + NX)

.^.. AD will increase

Result:

IS curve shifts to the right from IS₁ to IS₂ (Fig. 18.13(b))

At the given ER – є₁, income level should increase to Y₁, but at E₁, IS₂ ≠ LM

Reason:

LM curve is vertical straight line. It does not depend on the ER

To achieve Equilibrium at E₂ where IS₂ = LM,

ER rises from є₁ to є₂

Increase in ER leads to fall in NX by same amount

.^.. Income level decreases, it remains unaffected

Thus, NX (trade balance) is unaffected

Restrictive Trade Policy under Fixed ER (Not In Syllabus):

When Government tries to reduce import by imposing import quota, exports will increase, imports will decrease and thus NX will increase

As NX is a component of IS, increase in NX means shift in IS curve to the right from IS₁ to IS₂ (Fig. 18.14)

ER rises from є₁ to є₂

Equilibrium is at point B.

But at point B:

Fixed ER (є₁) < Equilibrium ER (є₂)

To maintain Fixed ER, Central Bank will buy $ (arbitrageur sells $)

Result:

Money supply will increase

LM curve will shift to the right from LM₁ to LM₂

ER falls from є₂ to є₁ and fixed ER is maintained

Income level rises from Y₁ to Y₂