Chapter 14 Flashcards
What is the definition of nominal exchange rate and real exchange rate?
Nominal Exchange Rate: Nominal Exchange Rate is the relative price of the domestic currency in terms of foreign currency, e
e: Number of foreign currency per unit of domestic currency
Nominal Depreciation: If the domestic currency picks fewer units of foreign currency (do it is weaker): e ↓
Nominal Appreciation: if the domestic currency picks more units of foreign currency (so it is stronger): e ↑
Real Exchange Rate: It is the relative price of domestic goods in terms of foreign goods, Ɛ. Ɛ = e * P / P* : numerator makes price comparable
Real Depreciation: if the domestic goods become relatively cheaper or foreign goods become relatively more expensive: Ɛ ↓
Real Appreciation: if the domestic goods become relatively more expensive, or foreign goods become relatively cheaper: Ɛ ↑
In the Mundell- Fleming Model, what happens if the nominal exchange rate, e, rises? Draw IS
Price levels is fixed, so the real exchange rate, Ɛ , rises
The domestic goods become more expensive relative to the foreign goods
Exports fall, imports rises
Net export falls
Planned expenditure falls
Inventory levels rises
Output/income, Y, falls
What is the Money Market Equilibrium in the Short Run? Draw LM. Then the the full Mundell-Fleming Model
IS: Y = C(Y - T) + I(r*)+ G + NX(e)
LM: Mbar/P = L(Y,r) ->( +,-)
Fiscal Policies Under Floating (Flexible) Exchange Regime: What happens when there is a expansionary fiscal policy under Floating (Flexible) Exchange Regime? Draw a graph.
Expansionary Fiscal Policy: G↑
Planned expenditure rises
Output/Income, Y, tends to rise
Demand for real money rises
People tend to sell bonds
Bonds become cheaper
Domestic interest rate, r, tends to rise above r*
Capital Inflow
Demand for domestic assets and domestic currency rises
Nominal Appreciation (stronger domestic currency)
Real Appreciation (relatively more expensive domestic goods): Ɛ↑
Exports falls, Imports rises
Net Exports falls, NX ↓
Planned Expenditure falls
Output/Income, Y, tends to fall
Overall Output/Income, Y, remains the same, as NX ↓ exactly cancels out G ↑
Also consumption and investment remain the same
Fiscal Policies Under Floating (Flexible) Exchange Regime: Explain the crowding out effect in a Closed Economy and Small Open Economy.
Explain the crowding out effect in a Closed Economy and Small Open Economy.
Closed economy: Fiscal policies crowd out private investment by causing the domestic interest rate to rise
Small open economy: Fiscal policies crowd out net exports by causing the exchange rate to appreciate
Monetary Policies Under Floating (Flexible) Exchange Regime: What happens when there is a expansionary monetary policy under Floating (Flexible) Exchange Regime?. Draw a graph.
Expansionary Monetary Policy M↑
The central bank buys bonds
Price of bonds rises
Domestic interest rate, r, tends to fall below r*
Capital Outflow
Demand for foreign assets and foreign currency rises
Nominal Depreciation (weaker domestic currency): e ↓
Real Depreciation (relative cheaper domestic goods): Ɛ ↓
Export rises and import falls
Net export rises, NX↑
Planned expenditure rises
Inventory levels falls
Output/Income, Y, rises
Consumption, c, rises
Also, investments, I, remains the same
Trade Policies Under Floating (Flexible) Exchange Regime: What happens if you apply a quota or tariff to improve trade deficit?
Applying Quotas or Tariffs to improve trade deficit:
Net Exports tends to rise, NX↑, at any exchange rate
Planned expenditure rises
Output/Income, Y, rises
Demand for real money rises
People tend to sell bonds
Bonds become cheaper
Domestic interest rate, r tends to rise above r*
Capital Inflow
Demand for domestic assets and domestic currency rises
Nominal Appreciation (strong domestic currency)
Real Appreciation: relatively more expensive domestic goods: Ɛ↑
Net exports tends to fall, NX↓
Overall, net exports, remains the same (these two forces on NX cancel each out)
Output/Income remains the same
What is a fixed (pigged) Exchange Regime? Draw the Graph
In the fixed exchange regimes, the policy makers set the nominal exchange rate: e = e
Under this regime, the central bank stands ready to buy or sell the foreign currency for domestic currency, to defend and support the predetermined rate, e
We assume that country is a a small open country with perfect capital mobility
This system fixes the nominal exchange rate, but in the long run, when prices are flexible, the real exchange rate can move even if the nominal rate is fixed
Excess Demand for Foreign Exchange (green): The central bank sells foreign exchange
Excess Supply of Foreign Exchange (red): The central bank buys foreign exchange
What is the difference between Fixed (Pegged) vs. Floating (Flexible) Exchange Regime?
Policymakers can choose only one out of money supply, M, and nominal exchange rate, e, to control. The other one must be left to market to determine
Floating Flexible Exchange Regime:
Market determines exchange rate, e
Policymakers set the money supply, M, by expansionary/contractionary monetary policies
Fixed (Pegged) Exchange Regime:
Market determines the needed money supply, M
Policymakers sets the exchange rate, e, by devaluation/revaluation policies
Fixed (Pegged) Exchange Regimes: What is a revolution policy and devaluation policy?
Revaluation Policy: If policymakers raise the fixed rate of exchange, e, making domestic currency stronger: e↑
Devaluation Policy: If policymakers reduce the fixed rate of exchange, e, making domestic currency weaker: e↓
Monetary Policies Under Fixed (Pegged) Exchange Regime: What happens when there is an expansionary monetary policy? Draw a Graph.
The monetary policy cannot move the LM* curve. The policy is ineffective to change output.
In the fixed exchange regimes, the money supply is endogenous and is used to maintain e
Under floating rates, monetary policy is very effective at changing output
Under fixed rates, monetary policy cannot be used to affect output
Expansionary monetary policy: M↑
The central bank buys bonds
Bond price rises
Domestic interest rate, r, tends to fall below r*
Capital Outflow
Demand for foreign assets and foreign currency rises
Depreciation pressure
But the central bank should keep exchange rates fixed, so it sells foreign currency
Money supply falls, M↓
Overall, the money supply remains the same (buying domestic bonds and selling foreign assets cancel each out)
The central bank has more domestic bonds and less foreign currency
Devaluation Policy: What happens with devaluation Policy? Draw a Graph.
Devaluation Policy: e↓
Domestic currency becomes weaker
Real depreciation (relatively cheaper domestic goods): Ɛ ↓
Export rises, Import falls
Net Export rises, NX↑
Planned expenditure rises
Inventories fall
Output/Income, Y, rises
Demand for real money rises
People tend to sell bonds
Bonds become cheaper
Domestic interest rate, r, tends to rise above r*
Capital Inflow
Demand for domestic assets and domestic currency rises
Appreciation pressure
But the central bank should keep exchange rate fixed, so it buys foreign currency
Money Supply, M, rises
Also Consumption, C, rises,
The interest rate, r and investment, I remain the same
Fiscal Policies Under Fixed Exchange Regime: What happens with expansionary fiscal policy?
Expansionary fiscal policy: G↑
Planned expenditure rises
Inventories fall
Output/Income, Y, rises
Demand for real money rises
People tend to sell bonds
Bonds become cheaper
Domestic Interest rate, r, tends to rise above r*
Capital Inflow
Demand for domestic assets and domestic currency rises
Appreciation rises
But the central bank should keep exchange rate fixed, so it buys foreign currency
Money Supply, M, rises
Also, consumption, C rise
The interest rate, r, exchange rates, e, and Ɛ, and investment I remains the same
Trade Policies Under Fixed Exchange Regime: What happens with applying import restrictions to improve trade deficit?
Applying quotas or tariffs to improve trade deficit:
Net export rises, NX↑, at any exchange rate
Planned expenditure rises
Inventories fall
Output/Income, Y, rises
Demand for real money rises
People tend to sell bonds
Bonds become cheaper
Domestic Interest rate, r, tends to rise above r*
Capital Inflow
Demand for domestic assets rises
Appreciation pressure
But the central bank should keep exchange rate fixed so it buys currency
Money supply, M, rises. Also, consumption, C, rises.
Note that interest rate, r, and the exchange rates, e, Ɛ remains the same, overall
What are Speculative Attacks?
Under a fixed exchange regime, the central bank should stand ready to buy/sell the foreign currency against the domestic currency
The money supply will adjust automatically to make the equilibrium exchange rate equal to the targeted exchange rate
Problem: If people come to the central bank to buy a large sum of foreign currency, the central bank foreign reserves may drain to zero. So, keeping the fixed rate becomes impossible
Speculative Attack: If due to a change in investors perceptions, like rumors about the central bank intentions to abandon the fixed rate or lack of enough reserves to support the fixed rate, people rush to buy foreign currency with the domestic currency, such that the central bank is forced to abandon the fixed regime, due to draining of its foreign reserves
Rumours about speculative attacks are self-fulfilling
How are speculative attacks avoided? What is the next step after this?
To avoid speculative attacks, economists believe, the fixed rate must be supported by a currency board
A currency board is an arrangement by which the central bank holds enough foreign reserves (currency) to back each unit of domestic currency. So, even if the whole domestic currency turned up at the central bank to exchange, the central bank never run out of foreign currency
Dollarization: Once a central bank has adopted a currency board, it might consider the next: abandoning the domestic currency altogether and letting its country use the foreign currency
Dollarization can happen on its own in high inflation economies not as a public policy
Two problems with dollarization
Losing government seigniorage (foreign government gets it)
Losing national pride
What is the impossible T?
Free Capital Outflows, Fixed Exchange Rate, Independent Monetary Policy
What are interest rate differentials? How is the LM curve modified with interest rate differentials?
The domestic and foreign interest rates may not be equaWhat are interest rate differentials?
The domestic and foreign interest rates may not be equal even for small open economies
r = r* +
Country Risks: The domestic country’s borrowers may default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk
Exchange Rate Risks (Expected Exchange Rate Changes): If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation
How is the LM curve modified with interest rate differentials?
Modifying the IS* curve, clearly when investors pay higher interest rate, due to higher risk premium, investment falls
IS* = Y = C(Y-T) + I( r* + ) + G + NX
+ ^INVESTMENT FALLS
LM* =Mp = L( Y, r* + , )
+ - +
