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Intermediate Macroeconomics Ch21 notes

Intermediate Macroeconomics Ch21 notes - Chapter 21...

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Chapter 21: Exchange Rate Regimes Flexible versus Fixed Exchange Rate System Under flexible exchange rate system, it is possible to introduce a real depreciation through nominal depreciation to reduce trade deficit or to get out of recession. Monetary expansion reduces the interest rate, leading to nominal depreciation for domestic currency. Under fixed exchange rate, nominal exchange rate is fixed and could not be adjusted. Domestic interest rate has to remain equal to the foreign interest rate. Given the above properties, it does not mean that a flexible exchange rate is always better than a fixed exchange rate. Given the real exchange rate: є * P EP = Given a fixed local and foreign price (P and P*), the real exchange rate (which affects the international competitiveness of a country) can only be adjusted through a change in the nominal exchange rate E. However, it can be conducted only under a flexible exchange rate system. In the longer run, the real exchange rate can be adjusted not only by changing the nominal exchange rate E, but also by a change in domestic price level relative to foreign price. Price adjustment in the longer run can take place in any economies, including those with fixed exchange rate. Aggregate Demand under Fixed Exchange Rates In an open economy with fixed exchange rate, the aggregate demand relation is = T G P P E Y Y , , * ( - , +, + ) This function form suggests that output depends on real exchange rate * P P E , E is fixed nominal exchange rate, P and P* are domestic and foreign price level. An increase in the real exchange rate (real depreciation) leads to a decrease in output. Under the fixed exchange rate, the aggregate demand is not affected by real money supply M/P since the central bank cannot change the interest rate which is pinned down by the foreign interest rate level. The price level in an open economy does not affect the real money supply M/P. It affects the real exchange rate level. An increase in domestic price level P tends to bring about real appreciation. Then there would be a drop in demand for domestic goods, a decrease in net exports and output. 1
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AD-AS Equilibrium in the Short Run and in the Medium Run The aggregate supply curve is specified as: - + = z L Y F P P e , 1 ) 1 ( μ The expected price level P e affects nominal wages and the actual price level. Higher output leads to higher employment, lower unemployment, higher wage and higher price level. The AD-AS equilibrium is given by the intersection of AD and AS curves. In the short-
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Intermediate Macroeconomics Ch21 notes - Chapter 21...

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