Topic 15: Shocks in the Financial & Exchange Market

Question 1

What are the effects of micreconomic reform on the financial & exchange market? Run through how all variables are solved.

Answer 1

Starting in the supply side

• Labour market clears and output increases
• The return on installed capital can then be calculated, which then increases, while the expected future return on installed capital may be exogenous (increase income is not expected to be permanent.)

On the demand side:

• Domestic savings is determined from S_d(Y₀,Y_F^e,G)
• From r_c^e, investment demand.
• From these, net foreign investment, I and S are determined.
• With the balance on the capital account determined, the current account is also determined
• In combination with import export demand (calculated from Y₀, Y*) the real exchange rate is then known.

Question 2

Run through a fiscal expansion in the financial & exchange market, which decreases domestic savings and increases net foreign investment demand.

Answer 2

• Increased net inflows increases the capital account - with the domestic supply of savings dimished firms must offer higher interest rates in order to finance the same amount of investment.
• The interest rate will then increase while the level investment also falls (some firms cannot afford the higher interest rate).
• As the foreign supply of savings has remained unchanged, while the local economy is less inclined to loan, investors will neccesarily lean foriegners them more heavily, increasing the capital account.
• The increased government spending raises aggregate demand for all corn, and as supply for home corn is fixed, the relative price of home corn rises, a real appreciation.

Question 3

Show the effects of a decrease in import tarrifs in the market for foreign exchange.

Answer 3

This causes an increase demand for foreign corn, and a tendency for the current account deficit to increase (consumer might rather buy cheap imports then invest overseas).

But in the diagram:

• Net inflows on the capital account are fixed.
• There is a change in the rate at which home & foreign corn are exchanged
• So the price of home corn must fall relative to the pre-tarrif price of foreign corn. So a real depreciation.