Exchange rates

Question 1

What is the nominal exchange rate?

Answer 1

the relative price of domestic currency in terms of foreign currency

Question 2

What is the real exchange rate ?

Answer 2

the relative price of domestic goods in terms of foreign good.

i,e Japanese big macs to us big macs

Question 3

What is the net exports function?

Answer 3

Relates the inverse relationship between net exports and the real exchange rate

When the real excahnge rate is realtively low Uk goods are realtively inexpensive, so UK net exports will be high

Whne the real exchange rate is high, UK goods become so expensive that we export less than we import

Question 4

How can you have a shift in the IS schedule?

Answer 4

Changes in aggregate demand shift the IS schedule. For a given interest rate:

• More optimism about future profits raises investment demand.
• Higher expected (future) incomes raise consumption demand.
• Higher government spending adds directly to aggregate demand. •

Any of these, by raising aggregate demand at a given interest rate, raises equilibrium output at any interest rate,

• And lead to an upward shift in the IS schedule.

Question 5

Exaplain the LM schedule

Answer 5

The liquidity preference money supply

money market is in equilibrium when money demanded equals money supplied

LM schedule shows different combinations of income and interest rates at which the money market is in equilibrium

Question 6

Explain shift in the LM schedule

Answer 6

Shifts in the schedule reflect a change in monetary policy.

• A rise in the target money supply means that money demand must also be increased to maintain money market equilibrium.
• This implies a rightward shift in the LM schedule.
• Output is higher, or interest rates lower, raising money demand in line with the rise in real money supply

Question 7

Explain equibllibrium in goods and money market

Answer 7

Bringing together the IS schedule (showing goods market equilibrium)

and the LM schedule (showing money market equilibrium)

We can identify the unique combination of real income and interest rate (r*, Y*) which ensures overall equilibrium.

Question 8

What is the policy mix to stabilise income around a high average level?

Answer 8

Question 9

What is the foregin exchange market

Answer 9

The international market in which one national currency can be traded for another

Question 10

What are fixed and felxible exchange rate schemes?

Answer 10

• In a fixed exchange rate regime – the national governments agree to maintain the convertibility of their currency at a fixed exchange rate.
• In a flexible exchange rate regime – the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves.

Question 11

Explain what happens if a country fixes their excahnge rate,

Answer 11

If a government fixes their excahnge rate at e1

If the demand for the currency is higher than equilbirum demand there is excess demand

The bank of the country must supply this demand to the other country in return for the other contries currency

This is added to reserves

Question 12

Explain Monetary Policy under Fixed exchange rates

Answer 12

An increase in nominal money supply

– tends to reduce interest rates

– leads to a capital outflow

– reducing money supply as the government seeks to maintain the exchange rate…

• …so monetary policy is powerless

– the government cannot fix independent targets for both money supply and the exchange rate

– domestic and foreign interest rates cannot diverge

Question 13

Explain Fiscal Policy under Fixed exchange rates

Answer 13

• An increase in government expenditure, in the short run, – stimulates output – money supply expands – there is no crowding-out as interest rates cannot rise
• (in the long run, – wages and prices adjust, affecting competitiveness – the economy returns to potential output)

Question 14

Explain Monetary Policy under Flexible exchange rates

Answer 14

Expansionary monetary policy does not raise world aggregate demand, it merely shifts D from foreign to domestic products , therfore increases in domestic income and employment are at the expense of losses abroad.

• The effect may be strong, but also temporary ,therefore shortrun effect because different inflationary pressures can rebalance the system in the long-run.

monetary policy is highly effective in the short run

, – but the effect is only transitional

Question 15

explain fiscal policy under Flexible exchange rates

Answer 15

Following an increase in government expenditure

, • the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate, – which dampens export demand.

• So fiscal policy is less effective (or ineffective) under floating exchange rates.

Question 16

Summarise floating and fixed, fiscal and monatory policy

Answer 16

Question 17

Floating vs fixed excahnge rates

Answer 17

Argument for floating rates: – allow monetary policy to be used to pursue other goals (stable growth, low inflation).

Arguments for fixed rates: – avoid uncertainty and volatility, making international transactions easier. – discipline monetary policy to prevent excessive money growth & hyperinflation.

Question 18

What is devaluation?

Answer 18

A devaluation (revaluation) reduces (increases) the par value of a pegged (fixed) exchange rate

With sluggish price adjustment, devaluation raises competitiveness and – eventually – impacts on the current account.

• In the long run, devaluation is unlikely to have much effect.