sol8 - DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA...

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D EPARTMENT OF E CONOMICS U NIVERSITY OF C ALIFORNIA , B ERKELEY F ALL 2007 ECON 182 Suggested Solutions to Problem Set 8 Problem 1: Stabilization Policy under Fixed Exchange Rate One of this week’s readings from The Economist, Baltic Blues, discusses that Latvia is reluctant to devalue its currency even when “its inflation rate and current account deficit soar, and speculators hover over its pegged exchange rate”. Consider two stabilization policies (1) fiscal expansion/contraction; (2) devaluation/revaluation. Choose the appropriate policy in each category and use IEB/RIP-IS/LM framework to analyze and compare the effects. Selected economic variables 2000 2001 2002 2003 2004 2005 2006 2007 GDP growth rate 6.91 8.04 6.47 7.20 8.68 10.60 11.93 11.2 CA (%) -4.78 -7.55 -6.64 -8.18 -12.93 -12.55 -21.09 -22.2 Debt/GDP (%) 12.3 14 13.5 14.4 14.5 12.5 10.6 Budget -2.8 -2.1 -2.3 -1.6 -1 -0.4 -0.3 0.4 CPI (%) 2.71 2.49 1.88 2.94 6.23 6.74 6.55 11.4 Unemployment (%) 14.4 13.1 12 10.6 10.4 8.7 6.8 5.5 Short term interest rate (%) 8.25 8.05 5.35 4.20 5.40 4.35 5.40 10.2 Nominal Exch Rate (/Euro) 0.57 0.56 0.61 0.67 0.70 0.70 0.70 0.70 Foreign Reserve (in m Lat) 563.4 777.3 788.4 830.5 1043.4 1399.8 2417 Balance of payments (in thousands of lats) 2002 2003 2004 2005 2006 Current account -382462 -522829 -961235 -1137296 -2375956 Financial Account 413045 485959 841205 1200520 2280861 .... Direct Investment 154595 145747 288389 337383 834004 .... Other investment 375263 501573 668225 1261679 2522293 ........ assets(other investment) -288395 -388203 -958605 -242665 -1046134 ........ liabilities(other investment) 663658 889776 1626830 1504344 3568427 .............. banks(liabilities) 601082 839043 1368089 1424380 2837572 .............. other sectors(liabilities) 71327 93217 227965 134149 678554 .... Reserve assets 979 -38286 -214700 -294052 -1103006 Net errors and omissions -43521 -6524 42135 -183003 -38065 Three key facts should be noted: Latvia lat is pegged to the euro and the analysis is under a fixed exchange rate regime. Internal balance and soft-landing is needed. In order to join the euro zone, Latvia also need to keep inflation under control. The current account has huge deficit and external balance is needed. Therefore, the equilibrium in IEB- RIP diagram is not achieved. The economic situation (such as in Figure 1) is at the point B which is under the IEB curve. a. Fiscal contraction (Figure 1) Under a fixed exchange rate regime, E e D E and i D i : If the government cut down the fiscal expen- diture, the IS curve shift inwards and output declines. Then the money supply decreases corresponding to lower money demand. More importantly, if the government can commit to contractionary policies, people expect a lower inflation rate in the future, which means e declines. Assume all foreign variables don’t change over time. Then r D i e rises, which also plays a role in cooling down the economy. This is depicted as a inward shift of LM curve. Now the economic situation in the IEB-RIP diagram jumps from point B to point A, still not in external balance. Thus, the government surplus must be large enough to make future domestic inflation less than foreign inflation rate, e < : Then by the equation L AST MODIFIED 2:17 PM , 11/17/2007 1
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D EPARTMENT OF E CONOMICS U NIVERSITY OF C ALIFORNIA , B ERKELEY F ALL 2007 ECON 182 q D EP = P we know Lativa will have a real currency depreciation even if the nominal exchange rate is pegged. Eventually, external balance will be restored.
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