Topic 17: Macroeconomic Analysis & Monetary Policy

Question 1

Analysis the effects of a monetary expansion in Rod’s complete model (when the labour market clears).

Answer 1

Nothing on the diagrams change, because all that is measured in volumes.

So the changes are all in the equations for real money supply (which is fixed) and real exchange (itself also fixed).

The excess supply of money is resolved by a increases in prices, which can be thought of as a decrease in the value of money - such that the real money supply stays the same.

As prices increase, in order to have the same real exchange rate, there is a nominal depreciation. All the changes are the same proportion as the intial.

Question 2

Analysis the effects of a bond financed fiscal expansion in Rod’s complete model (when the labour market clears, and monetary policy targets M_S).

Answer 2

There is a reduction in government, and so public savings.

Government bonds by competing with corportate bonds decrease the bodn price, raising the real interest rate r, which causes foreigners to rebalance their portfolios towards the home country, causing a rise in net inflows.

There is then an increase in the capital account, and a decrease in the current. In order for transactions on the forex to balance, there must be a real appreciation - the increased demand for capital inflows makes the purchase of foreign imports cheaper and local exports dearer - a real appreciation. As the interest rate has risen, the cost of holding money is higher and the demanded real money balances falls. As the real supply must match, and M_B is targeted, there must be an increase in prices.

This means the change in the nominal exchange rate is ambigous.

Question 3

Analyse the effects of a bond financed fiscal expansion with price level targeting and clearing labour markets. Skip the explination of the graphical changes.

Answer 3

There is a real depreciation and a decrease in real money balances.

As P_Y is targeted, the latter means that M_B must decrease, else prices would increase.

The former means that there must be a nominal appreciation, otherwise transactions on the forex would not balance.

Question 4

Analyse the effects of a tarrif reduction when all markets clear, when a) M_S is targeted b) P_Y is targeted amd c) E is targeted.

Answer 4

There is a real depreciation.

As the interest rate (both) and the demand for real money balances is unchanged, so there is actually no difference in central bank targeting, P_Y & M_B are both held constant. So there is a nominal depreciation.

When E is targeted, the depreciation must be absorbed by prices. As the prices decrease, so to must the nominal money supply.

Question 5

Summarise the effects of tarrif reductions:

Answer 5

Tarrif reductions can contract the economy in the short run in countries with fixed exchange rate regimes (as prices decrease). But this is rare, as there are offsetting benifits

• Allocative efficiency gains from trade reform that a one-good model misses. Especially so if multiple countries reduce tarrifs simultaneously.
• Productivity gains raise the expected future return on installed capital, inducing greater investment and output

Question 6

Analyse the effect of a fiscal expansion with price level targetting.

Answer 6

New bond issues decreases bond prices, increases real interest rate.

Increased real interest rate attracts foreign investment, so the balance on the capital account increases.

The balance on the current account then decreases, and since there are increased capital inflows on the forex, this necessarily means must be made imports cheaper and exports dearer, (a real appreciation) for transactions on the forex to balance. We can also consider that demand for all goods has increased, and as home corn is supply inelastic, it’s relative price must increase.

The higher real interest rate means the real money balance demanded must fall, as the opportunity cost of holding money has increased. In order to keep P_Y constant, M_S must then decrease. And so there must be a nominal appreciation to match the real appreciation.

Question 7

How (in what direction) does fiscal policy affect the exchange rate. Is it a useful to do so?

Answer 7

Fiscal expansions cause appreciations. Contractions, depreciations.

We would not use fiscal policy to affect exchange rate changes, because of debt problems, the time lag and the ease of using monetary policy instead.

Question 8

Analysis the affects of a decrease in foreign reserves.

Answer 8

At any interest rate, net inflows on the capital account are increased. THe supply of savings to finance domestic investment rises, so lower yeiling probjects can be implemented with r decreasing.

Net inflows on the current account increase, so imports rise relative to export.

Demand for all corn rises, but as home corn is inelastic in supply in supply the relative price of home corn rises, so there is a real apprecation.

At the lower real interest rate, the opportunity cost of holding money is reduced, and the real money balance demanded increases.

If the money from the sale of reserves is absorbed, then the money supply will be contracting, so the price level must fall substantually as m_S is decreasing. This means that E must rise even more. Big deflation is not nice.

Alternatively the central bank could sterilise by buying enough government bodns to hold the nominal money supply constant.

This means P_Y must fall, but not so drastically. The nominal appreciation is lower then before.

Or the central bank could target the price level. This means that M_S must increase, and there will be a small appreciation (relative to the other policies).

Question 9

What are some possible targets of Monetary Policy?

Answer 9

• The unemployment rate (through the philips curve relationship, populat through 1950-70)
• The nominal money supply (Monetarist). Became difficult to implement as diversity of asset types increased and measurements of money became complex.
• Nominal GDP (P_YY). Can lead to runaway inflation if growth does not meet target.
• Nominal exchange rate. Crux of the developing world
• The real exchange rate (advocated in the 1980’s for some developed countries. Implemented by China until 1994).
• The price level, P_Y or P_C. Most industrial countries today have monetary policies that target this (or rather, the rate at which it grows).