EXCHANGE RATE Flashcards
Why is the IS curve more elastic in an open economy
Because when the interest rate goes up, both investment and Net exports go down. The added effect comes from the impact that a higher interest rate has on the exchange rate.
Suppose that a government is fighting deficits and decides to reduce its expenditures and increase its tax rates. What impact will this have on interest rates, real GDP and the exchange rate?
It is a negative aggregate demand shock will result in lower real GDP (Shift of aggregate demand to the left) but lower interest rates and depreciate the currency.
How can a positive supply shock lead to an increase of investment in an open economy?
By shifting AS (aggregate supply) down it decreases prices, which means that people do not need as much money to transact but with M/P increasing, the only way to equilibrate the money market is by lowering the interest rate, which has a positive impact on investment.
How would you change your answer in c) if the Central Bank intervene to keep interest rates in line with its policy rate of before the supply shock had happened?
By lowering money supply (a restrictive monetary policy), the central Bank reestablishes the previous rate. LM shifts to the left. That eliminates the earlier drop of interest rate and investment is back to where it was.
a) What is the interest rate parity condition?
It is a condition that states that domestic interest rate must be equal the the foreign interest rate plus expected appreciation.
Arbitrage means that : i = i* + (e – expected e)/e or i – i* = (e – expected e)/e
b) If investors expect a depreciation of the $CA, why is it likely to happen immediately?
With i and i* not changing, with expected e going down, e must drop for interest rate parity to hold.
c) Suppose that both the Federal Reserve and the Bank of Canada are adopting restrictive monetary policies, what impact will this have on the value of the $CA?
It depends both i and i* will go up. If i increases more than i* then e will go up for given expectations. It depends both i and i* will go up. If i increases less than i* then e will go down for given expectations.
d) If the $CA is valued at $US 0,71/$CA 1.00 and it is expected to depreciate, what does it say about the interest rate differential?
That the interest rate differential i-i* is positive.
We wish to study how the adjustment of the exchange rate modifies the effect of different economic shocks on production. For each of the shocks below, (i) first, use the IS-LM model to describe the effect on interest rates of each of the shocks; (ii) then describe how changing interest rates influences the exchange rate; (iii) finally, indicate whether the exchange rate adjustment and the resulting variation in exports attenuate or amplify the variations in production and of employment.
a) A decline in business confidence reduces investment.
Shifts IS to the left, reduces interest rate and output, the currency depreciates, net exports go up, which attenuates to drop of real GDP and employment.
We wish to study how the adjustment of the exchange rate modifies the effect of different economic shocks on production. For each of the shocks below, (i) first, use the IS-LM model to describe the effect on interest rates of each of the shocks; (ii) then describe how changing interest rates influences the exchange rate; (iii) finally, indicate whether the exchange rate adjustment and the resulting variation in exports attenuate or amplify the variations in production and of employment.
b) The government reduces income tax. Changes the slope of IS.
For a given LM curve, interest rate is higher but GDP is also higher with a lower tax rate. The currency appreciates, net exports go down, which, attenuates to increase of real GDP and employment compared to the lower tax case.
For a given LM curve, interest rate is now lower (than the higher tax rate case) but real GDP is also lower. The currency depreciates up, net exports go up, which attenuates to drop of real GDP and employment.
We wish to study how the adjustment of the exchange rate modifies the effect of different economic shocks on production. For each of the shocks below, (i) first, use the IS-LM model to describe the effect on interest rates of each of the shocks; (ii) then describe how changing interest rates influences the exchange rate; (iii) finally, indicate whether the exchange rate adjustment and the resulting variation in exports attenuate or amplify the variations in production and of employment.
c) The government is reducing the budget allocated to infrastructure spending.
G goes down, IS shifts left. This reduces interest rate and output, the currency depreciates, net exports go up, which attenuates to drop of real GDP and employment.
We wish to study how the adjustment of the exchange rate modifies the effect of different economic shocks on production. For each of the shocks below, (i) first, use the IS-LM model to describe the effect on interest rates of each of the shocks; (ii) then describe how changing interest rates influences the exchange rate; (iii) finally, indicate whether the exchange rate adjustment and the resulting variation in exports attenuate or amplify the variations in production and of employment.
d) The Bank of Canada implements a restrictive monetary policy. LM shifts left (upward). Interest rates increase, real GDP goes down. This exchange rate goes up.
net exports go down, which amplifies to drop of real GDP and employment.
