Week 10 Exchange rate policy

Question 1

What is a sudden stop?

Answer 1

Before 2008 countries in Europe were enjoying negative current account and having flow of capital from other countries.

This caused a very large unemployment.

Question 2

What is a real exchange rate depreciation in terms of another variable?

Answer 2

Real exchange rate depreciation is an increase in e

Question 3

What happened to the Eurozone countries during the sudden stop?

What was particularly strange that happened to Eurozone

Answer 3

-CA was deficits but then started getting less negative
-wages were increasing after 2008
-Unemplyoment was increasing after 2008

-These eurozxone countries did not have a real exchange rate depreciation.
As they were part of a monetary union

Question 4

How do you show wage rigidities?

Answer 4

wt is greater than or equaled to lamda wt-1

With nominal rigidities lamda is close to 1

Question 5

What empirical data shows evidence for nominal wage rigidities.

Answer 5

In great depression unemplyoment rose by 31%
but wages only fell by 0.6% in same time period

Question 6

What is a historical example that being in a monetary union is bad?

Answer 6

When 1929 depression hit some countries like UK left Gold Standard

As a result,

Question 7

What is the set up of that pins down exchange rate and unemployment

Answer 7

Two periods
two goods traded and non traded

PT = domestic price of traded goods
PN = domestic price of non-traded goods
P*T = foreign price of traded goods
St = nominal exchange rate
pt = PN/PT

Law of one price PT = PT . ST
Let PT =1
B*1 which are denominated in

Question 8

What is a case study of a country that shows the impact of having a fixed exchange rate with a sudden stop

Answer 8

Argentina 1996-2006
After 1996 they had sharp increase in unemplyoment
-Nominal wages rose
-Real wage rose

In 2002 they stopped pegging their currency to the dollar and devalued it.

This then causes a large drop in unemployment
And a drop in the real wage

Question 9

What do fixed exchange rate and nominal wage rigidities imply in tandem?

Answer 9

That real wages are not able to move.

Question 10

What is the relative price of non-tradeables in the two period model?

Answer 10

pt = PN/ PT

Question 11

What is the real exchange rate in the two period model and why is this?

Answer 11

Equaled to the relative price of non traded good PN / PT

Question 12

What does relative price mean in the two period model?

Answer 12

-It is the price of non-traded goods w.r.t traded goods

Question 13

What is the problem of the households in the traded and non traded goods two period model?
what is the framework?

Answer 13

C1T = consumption period 1 of traded goods
C1N = consumption period 1 of non traded goods

C2T = consumption period 2 of traded goods
C2N = consumption period 2 of non traded goods
Yt = income in terms of tradable.
r1 interest rate on assets

Households want to max
U(C1T, C1N) + U(C2T, C2N) S.T BC

Question 14

What are the one period budget constraint in the model with traded and non traded goods

How do we get the IBC?

Answer 14

P1T . C1T + P1N .C1N + PT . B1 = PT . Y1 + (1+r0)B0

P2T . C2T + P2N . C2N + PT . B2 = PT . Y2 + (1+r1) . B1

We divide everything by PT

B*2 = 0

IBC
c1T +p1C1N + C2T + P2C2N / 1+r1 = Y1 + Y2 / 1+r1

Question 15

What is a first order condition given by the traded and non-traded good model?

What can this be interpreted as?

Answer 15

U1(C1N, C1T) / U2(C2N, C2T) = p1

MRS between tradable and non-tradable = relative price / rer (NT w.r.t tradable

This is because p1 is relative price of non traded so if this increases they switch between non traded to traded.

Can be interpreted as the demand function of non-tradables as a function of the RER.

Question 16

What type of slope does the demand F.O.C have with the household with traded and non-traded and why is this?

What is a caveat for this?

Answer 16

Negative slope
As if relative price of Nt increases it means that PNT increases which means they will consume less PNT

Needs to be a normal good

Question 17

What is the demand F.O.C with a log function and what does this show

Answer 17

p1 = 1-a/a (CT1/CN1)
CN is a negative function of p1

Question 18

What is the impact of an interest rate increase that causes a sudden stop?

Answer 18

higher r causes C1T to decrease

Question 19

What is the production side of the economy with traded and non-traded goods?

Answer 19

QTN = F(ht) where ht is hours of labour.
Where F is an increasing and concave function.

Nominal profits of firms are
PNT . QTN - Wt . ht

Wt is the nominal wage

Divide by PT

pt . F(ht) - (Wt/St)ht

Question 20

What is the demand for labour first order condition?

Answer 20

pt = (wt/st) / F’(ht)

Demand for labour in non-traded sector

Question 21

How can you show the supply of non-traded goods?

Why is the relationship like this?

Answer 21

h on x axis
p on y axis

upward sloping line.

higher prices increase the value of marginal product.

Question 22

What is the behaviour of the supply of non-traded goods and what does this tell us?

Answer 22

• As pt = Wt/St / F’(ht)

as nominal rigities are present Wt > equaled to gamma Wt-1

As they belong to monetary union nominal exchange rate is fixed.

Therefore, demand for non-traded goods fall, this means the value of MP decreases and thus the schedule can only shift up.

Question 23

What is the condition of demand in nontraded good markets?

Answer 23

As they cannot be exported the demand of non traded goods must be equaled to supply when market clears.

cNT = QNT = F(ht)

Question 24

What is the supply of hours worked in the nont traded goods model?

What impact does this have on the model?

Answer 24

Workers supply h bar hours inelastically, but may not be able to sell them all as firms are constrained.
ht is less than or equaled to h bar

• it means there is unemployment .

Question 25

What is the impact of a devaluation of currency on the supply of non traded goods schedule?

Answer 25

• it causes the schedule to shift down
  This is because St falls causes the numerator to decrease.

Question 26

Graphically what does the demand of non-traded goods look like?

Answer 26

h x axis
p y axis
downard sloping line.

Question 27

What is the impact of a sudden stop on the demand of non-traded goods?

Answer 27

It causes a downwward shift of the demand schedule as consumption of traded goods decreases.

Question 28

What is the equilibrium before sudden stop? (Fixed exchange rate)

Answer 28

Start with the demand schedule
Start with the supply schedule
This forms equilibrium A

As the sudden stop decreases the demand for traded goods this causes the demand schedule to fall.
Forming equilibrium B

Supply function does not shift due to nominal rigidities and fixed exchange rate.

The new equilibrium B causes unemployment to increase.

To reach point C
You cut workers,
Cut wages
Or devalue exchanunemployment is to bring the economy to point C but this means shifting down the supply curve.

Question 29

What are the policies that a country can adopt to avoid a surge in unemployment?

Answer 29

Devaluate currency - but this is not feasible in EU

-Push MU to increase inflation as increasing inflation will decrease real wages.
-Labour market reforms to reduce real wages.
-Impose wage subsidies.

Question 30

Show how wage subsidies can reduce unemployment?

Answer 30

Assume government introduces subsidy tal1 (government pages a proportion of wage bill).

This changes the profit function to:

ptF(ht) - (1- tal t )(Wt/ St)ht

FOC
pt = (1-tal1)(Wt/St)/ F’(ht)

Therefore if gov increase subsidy this decreases the numerator and thus shifts the supply curve down to restore employment.

Question 31

How would you work out the wage subsidy that causes full employment?

Answer 31

You find the wage subsidy for supply at h BAR full employment
You find the wage subsidy for demand as C1N = F(hbar)

both are equaled to p1 then you make them equal and then find the wage subsidy.