Economic Policies under different Exchange Rate Regimes

Question 1

what is monetary policy?

Answer 1

monetary policy manipulates the money supply to achieve policy goals such as a rise in income

Question 2

how does the FE-LM-IS model react to a rise in the money supply for a flexible exchange rate?

Answer 2

an increase in the money supply will shift the LM curve to the right. if we ignore the foreign exchange market equillbrium line (horizontal) then this will drive the interest rate down and stimulate investment demand and increase income. however this point is not feasible as the foreign exchange market is not in equillbrium. as soon as the domestic interest rate is lower than the international interest rate the international investors will move out of domestic bonds and so get rid of domestic currency. this increases the supply of the domestic currency and leads to a depreciation. this will make our exports relatively cheaper and so the IS curve will move right until the IS curve intersects the LM curve along the FE line

Question 3

how does the FE-IS-LM model react to a rise in fiscal spending under a flexible exchange rate?

Answer 3

a rise in the government spending will lead to an outward shift in the IS curve. if the interest rate was to remain at the world interest rate then there will be an excess demand for money as income has increased. this excess demand in the money market will put upward pressure on the interest rate. as long as the domestic interest rate is greater then the world interest rate, there will be an increased demand for domestic currency. the domestic currency will then appreciate causing the exchange rate to decrease making the exports more expensive and imports cheaper, therefore, causing the IS curve to shift to the left.

Question 4

what is the important insight about fiscal policy under a flexible exchange rate?

Answer 4

under a system of flexible exchange rates and when capital is perfectly mobile across borders, fiscal policy does not give the government leverage over aggregate income. aslong as the central bank holds the money supply constant there will be crowding out.

Question 5

how does the FE-IS-LM model react to a rise in the fiscal spending under a fixed exchange rate?

Answer 5

a rise in government spending will lead to an outward shift in the IS curve. if the interest rate was to remain at the world interest rate then there will be an excess demand for money as income has increased. this excess demand in the money market will put upward pressure on the interest rate. in a system of fixed exchange rates, the excess demand for money cannot be eliminated by appreciation so the central bank must supply the rest. this means the IS curve cannot move back but the LM curve shifts to the right.

Question 6

what type of exchange rate is best for fiscal policy?

Answer 6

a fixed exchange rate is more effective for a fiscal policy

Question 7

how does the FE-IS-LM model react to a rise in the money supply under a fixed exchange rate

Answer 7

if the money supply is increased via the purchase of domestic bonds by the central bank then the LM Curve will shift right. this increased liquidity will drive down the interest rate. this will cause investors to get rid of domestic bonds creating an increase in supply for the domestic currency. as the exchange rate is fixed the central bank must purchase the supply. this will remove liquidity from the system causing the LM curve to shift all the way back to the original postion.

Question 8

what is comparative statistic anaylsis?

Answer 8

comparative statistic analysis looks at how equillbrium positions change after policy changes. it says nothing about whether and how the economy gets there.

Question 9

what is dynamic anaylisis?

Answer 9

dynamic anaylsis looks at whether an equillbrium is stable and traces the transition from one equilibrium to another.

Question 10

what is a rule of thumb about prices in the financial markets?

Answer 10

prices in the financial markets adjust instantaneously for example the interest rate and the exchange rate. this keeps the money market and the foreign exchange market where the interest rate and the exchange rate play a key role in equating the supply and demand in equilibrium at all times

Question 11

what is a rule of thumb for the goods market?

Answer 11

the goods market output adjusts slowly. if a firm experiences a rise or fall in sales then they need time to gear up or scale down production. this works in the same way for imports and exports where there may be prexisting contracts or need to find new suppliers

Question 12

how does the LM-IS-FE model respond to time lags after a rise in fiscal spending under a fixed exchange rate?

Answer 12

the expenditure increase will shift the IS curve out immediately however aslong as the rise in income does not occur instantaneously then the money market and the foreign exchange market can remain in the previous equilibrium with the goods market having excess demand. however as the income begins to gradually increase the demand for money will gradually increase therefore shifting the LM curve gradually to the right until all curves are in equilibrium at the same point

Question 13

what is the equation for the FE market in a dynamic and why is this important?

Answer 13

it is the uncovered interest parity which is i = world + [ E* - E )/ E] . it is important because it takes into account depreciation.

Question 14

how does depreciation affect the FE curve in a dynamic model?

Answer 14

expected depreciation will either move the horizontal FE curve up or down

Question 15

what is the advantage of using the linear difference of the logarithm of exchange rate expectations e* and e?

Answer 15

the linear difference e*-e proxies the percentage deviation of the exchange rate from equillibrium

Question 16

what is the equivalent formula to the expected deprecaition?

Answer 16

[(E- E)/ E] = d (e-e) where E* is the expected exchange rate and E is the exchange rate and e* and e are the logarithms of them. d is a parameter that measures the speed at which the exchange rate is expected to regress to e*

Question 17

what is a equation for the foreign exchange market equilibrium condition that takes into account depreciation using logs?

Answer 17

i = iworld + d(e*-e)

Question 18

what is the gradient of the FE curve on the interest - exchange rate graph?

Answer 18

the gradient is equal to -d

Question 19

what does the FE curve on the interest - exchange rate graph show?

Answer 19

it shows that the foreign exchange market can be in equilibrium for many different interest rates, if only the interest rate is combined with a specific exchange rate

Question 20

if i falls short of i world what readjusts this in a floating exchange rate

Answer 20

it is made up by an expected appreciation. therefore the exchange rate has to rise above its equilibrium value and then investors expect it to appreciate (fall) back towards its equilibrium postion

Question 21

what is exchange rate overshooting?

Answer 21

exchange rate overshooting occurs if the immeditate response of the exchange rate to a disturbance ( such as a money-supply increase) exceeds the response that is needed in the long run

Question 22

what occurs when the government raises spending when the economy is already operating at full capacity at a fixed exchange rate?

Answer 22

the governent increasing spending unser a fixed exchange rate leads to a shift in the IS curve to the right. the induced money supply increase shifts the LM curve to the right. however at the new temporary equilibrium, the income is higher than the potential income so as a result prices must rise. this affects the IS curve as the real exchange rate will appreciate which shifts the IS curve to the left. it also shifts the LM curve to the left as if the nominal money supply remains constant but the price level increases then the real money supply will decrease as real money supply equal M/P

Question 23

what occus when the money supply increases under a flexible exchange rate when the economy is operating at full capacity?

Answer 23

the money supply shifts the LM curve to the right, this will push down the interest rate leading the home currency to depreciate. this will then stimulate net exports shifting the IS curve to the right. however at this point the income is greater then the potential income so prices begin to rise which will push the IS curve to the left as the domestic goods become more expensive relative to foreign goods appreciating the currency. also the real money supply will decrease so the LM curve will be shifted to the left