IEU - Lecture 11 - National and Global Choices

IEU - Lecture 11 - National and Global Choices - Izmir...

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Izmir University of Economics ECON 306 INTERNATIONAL ECONOMICS Lecture 11 National and Global Choices: Floating  Rates and the Alternatives
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Effects of macroeconomic shocks Different types of shocks have different effects, depending on  which exchange rate policy is chosen.  Internal shocks , especially domestic monetary shocks, are  less disruptive  to the domestic economy with a  fixed  exchange rate External shocks , especially international trade shocks, are  less disruptive  with a  floating exchange rate.  If a country believes that it is mainly hit with internal shocks, it  would favor a fixed rate; if it believes that it is mainly hit by  external shocks, it would favor a floating rate.
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Effects of macroeconomic shocks Monetary policy  is  less effective  as an independent policy  influence on the domestic economy with a  fixed exchange  rate  (compared to its effectiveness with a floating rate).  Differences in the effectiveness of  fiscal policy  depend on  the  responsiveness of capital flows  to interest rate  changes.  The key conclusion is that a country that desires to use  monetary policy to address domestic objectives will favor a  floating exchange rate.
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     i                                 Y 0       i 0 LM      BP 0      IS 1/2 BoP (+) (too much $) If money demand  increases the LM curve  moves to the left and  causes a BoP surplus. The capital account  improves due to higher  capital inflow (‘r’ is higher)  and current account  improves due to lower  imports (Y is lower).  Effects of macroeconomic shocks (Money demand increases - Fixed ER Policy)
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     i                                 Y 0       i 0 LM      BP 0      IS Effects of macroeconomic shocks (Money demand increases - Fixed ER Policy) With the ER fixed, the government must buy foreign currency which increases money  supply and shifts the LM curve to the right. 2/2 Buy $, sell TL Ms The extra money  demand is now met by  an increased money  supply.  Y remains the same.
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     i                                 Y 0       i 0 LM      BP 0      IS Effects of macroeconomic shocks (Money demand increases – Flexible ER Policy) 1/3 If money demand  increases the LM curve  moves to the left and  causes a BoP surplus. The capital account  improves due to higher  capital inflow (‘r’ is higher)  and current account  improves due to lower  imports (Y is lower).  BoP (+) (too much $)
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     i                                 Y 0       i 0 LM      BP 0      IS Effects of macroeconomic shocks
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This note was uploaded on 08/06/2009 for the course ECONOMICS ECON 306 taught by Professor Alperduman during the Spring '09 term at Izmir University of Economics.

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IEU - Lecture 11 - National and Global Choices - Izmir...

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