Chapter 12 - Chapter 1 2 Aggregate Demand in the Open...

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Unformatted text preview: Chapter 1 2 Aggregate Demand in the Open Economy 123 4. The following table lists some of the advantages and disadvantages of floating versus fixed exchange rates. Table 12—1 Floating Exchange Rates Advantages: Allows monetary policy to pursue goals other than just exchange—rate stabilization, for example, the stability of prices and employment. Disadvantages: Exchange-rate uncertainty is higher, and this might make international trade more difficult. Fixed Exchange Rates Advantages: Makes international trade easier by reducing exchange rate uncertainty. It disciplines the monetary authority, preventing excessive growth in M. As a monetary rule, it is easy to implement. Disadvantages: Monetary policy cannot be used to pursue policy goals other than maintaining the exchange rate, As a way to discipline the monetary authority, it may lead to greater instability in income and employment. 5. The impossible trinity states that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy. In other words, you can only have two of the three. If you want free capital flows and an independent monetary poli- cy, then you cannot also peg the exchange rate. If you want a fixed exchange rate and free capital flows, then you cannot have independent monetary policy. If you want to have independent monetary policy and a fixed exchange rate, then you need to restrict capital flows. Problems and Applications 1. The following three equations describe the Mundell—Fleming model: Y: C(Y—T)+I(r) + G+NX(e). (IS) M/P = L(r, Y). (LM) r = rl‘. In addition, we assume that the price level is fixed in the short run, both at home and abroad. This means that the nominal exchange rate e equals the real exchange ratee . a. If consumers decide to spend less and save more, then the [8* curve shifts to the left. Figure 12—8 shows the case of floating exchange rates. Since the money sup— ply does not adjust, the LM* curve does not shift. Since the LM* curve is unchanged, output Y is also unchanged. The exchange rate falls (depreciates), which causes an increase in the trade balance equal to the fall in consumption. 124 Answers to Textbook Questions and Problems 4 E Figure 12—8 Exchange rate as 4— m Y] Y Income, output Figure 12—9 shows the case of fixed exchange rates. The LS"k curve shifts to the left, but the exchange rate cannot fall. Instead, output falls. Since the exchange rate does not change, we know that the trade balance does not change , either. i Figure 12—9 Exchange rate at Income, output In essence, the fall in desired spending puts downward pressure on the inter- 3 est rate and, hence, on the exchange rate. If there are fixed exchange rates, then the central bank buys the domestic currency that investors seek to exchange, and provides foreign currency, shifting LM* to the left. As a result, the exchange rate does not change, so the trade balance does not change. Hence, there is nothing to offset the fall in consumption, and output falls. Chapter 1 2 Aggregate Demand in the Open Economy 125 b. If some consumers decide they prefer stylish Toyotas to Fords and Chryslers, then the net—exports schedule, shown in Figure 12—10, shifts to the left. That is, at any level of the exchange rate, net exports are lower than they were before. 6 Figure 12—10 4—. {— NXl NX2 NX Exchange rate Net exports This shifts the IS‘” curve to the left as well, as shown in Figure 12—11 for the case of floating exchange rates. Since the LM’k curve is fixed, output does not change, while the exchange rate falls (depreciates). e :x: LM Figure 12—11 Exchange rate Income, output The trade balance does not change either, despite the fall in the exchange rate. We know this since NX = S — I, and both saving and investment remain unchanged. When consumers prefer to buy foreign cars, this will decrease net exports. The resulting decline in the value of the exchange rate will increase net exports and offset the decline, such that net exports remains unchanged Figure 12—12 shows the case of fixed exchange rates. The leftward shift in the IS:k curve puts downward pressure on the exchange rate. The central bank buys dollars and sells foreign exchange to keep 2 fixed: this reduces M and shifts the LM”: curve to the left. As a result, output falls. 126 Answers to Textbook Questions and Problems Figure 12—12 Exchange rate NI Income, output The trade balance falls, because the shift in the net exports schedule means that net exports are lower for any given level of the exchange rate. c. The introduction of ATM machines reduces the demand for money. We know that I equilibrium in the money market requires that the supply of real balances M / P § must equal demand: * M/P = L(r*, Y). A fall in money demand means that for unchanged income and interest rates, the right-hand side of this equation falls. Since M and P are both fixed, we know that the left—hand side of this equation cannot adjust to restore equilibrium. We also know that the interest rate is fixed at the level of the world interest rate. This means that income—the only variable that can adjust—must rise in order to increase the demand for money. That is, the LM* curve shifts to the right. Intuitively, the decline in money demand will put downward pressure on the interest rate. This will cause capital outflow until balance is restored because in this model the interest rate will remain equal to the world interest rate. As capital flows out of the economy, the exchange rate will fall. This will increase net exports and output. Figure 12—13 shows the case With floating exchange rates. Income rises, the exchange rate falls (depreciates), and the trade balance rises. Figure 12—13 Exchange rate Income, output Chapter 1 2 Aggregate Demand in the Open Economy 127 Figure 12—14 shows the case of fixed exchange rates. The LMil‘ schedule shifts to the right; as before, this tends to push domestic interest rates down and cause the currency to depreciate. However, the central bank buys dollars and sells foreign currency in order to keep the exchange rate from falling. This reduces the money supply and shifts the LMP‘ schedule back to the left. The LM’” curve contin— ues to shift back until the original equilibrium is restored. e LM~ Figure 12—14 A V Exchange rate NI Y1 Y Income, output In the end, income, the exchange rate, and the trade balance are unchanged. 2, The economy is in recession, at point A in Figure 12—15. To increase income, the cen- tral bank should increase the money supply, thereby shifting the LM* curve to the right. If only that happened, the economy would move to point B, with a depreciated exchange rate that would stimulate exports and raise the trade balance. To keep the exchange rate from depreciating and the trade balance from rising, the fiscal authori— ties should cut taxes or increase government spending. That would shift the IS* curve to the right, so that the economy would move to point C. Under the assumption in the chapter that net exports depend only on the exchange rate, this would keep the trade Figure 12-15 Exchange rate Income, output 1 28 Answers to Textbook Questions and Problems balance from changing. The increase in output and income would, instead, reflect an increase in domestic demand. (Note that without the monetary expansion, a fiscal expansion by itself would lead to a higher exchange rate—so the increase in domestic demand would be offset by a reduction in the trade balance. i 3. a. The Mundell~Fleming model takes the world interest rate r"k as an exogenous variable. However, there is no reason to expect the world interest rate to be con- stant. In the closed-economy model of Chapter 3, the equilibrium of saving and investment determines the real interest rate. In an open economy in the long run, the world real interest rate is the rate that equilibrates world saving and world investment demand. Anything that reduces world saving or increases world i investment demand increases the world interest rate. In addition, in the short run with fixed prices, anything that increases the worldwide demand for goods or reduces the worldwide supply of money causes the world interest rate to rise. b. Figure 12—16 shows the effect of an increase in the world interest rate under float- ing exchange rates. Both the IS* and the LM* curves shift. The [8* curve shifts to the left, because the higher interest rate causes investment [(r‘“) to fall. The LM* g curve shifts to the right because the higher interest rate reduces money demand. Since the supply of real balances M / P is fixed, the higher interest rate leads to an i excess supply of real balances. To restore equilibrium in the money market, income must rise; this increases the demand for money until there is no longer an excess supply. Intuitively, when the world interest rate rises, capital outflow will increase as the interest rate in the small country adjusts to the new higher level of the world interest rate. The increase in capital outflow causes the exchange rate to fall, causing net exports and hence output to increase, which increases money demand. Figure 12-16 Exchange rate Yl——“’Y2 Y Income, output We see from the figure that output rises and the exchange rate falls (depreciates). Hence, the trade balance increases. Chapter 1 2 Aggregate Demand in the Open Economy 129 Figure 12—17 shows the effect of an increase in the world interest rate if exchange rates are fixed. Both the 18* and LM”: curves shift. As in part (b), the 18* curve shifts to the left since the higher interest rate causes investment demand to fall. The LM* schedule, however, shifts to the left instead of to the right. This is because the downward pressure on the exchange rate causes the central bank to buy dollars and sell foreign exchange. This reduces the supply of money M and shifts the LM’k schedule to the left. The LM”: curve must shift all the way back to LM in the figure, Where the fixed—exchange—rate line crosses the new [8* curve. Figure 12—17 Exchange rate ml Y2 YI Y Income, output In equilibrium, output falls while the exchange rate remains unchanged. Since the exchange rate does not change, neither does the trade balance. A depreciation of the currency makes American goods more competitive. This is because a depreciation means that the same price in dollars translates into fewer units of foreign currency. That is, in terms of foreign currency, American goods become cheaper so that foreigners buy more of them. For example, suppose the exchange rate between yen and dollars falls from 2.00 yen/dollar to 100 yen/dollar. If an American can of tennis balls costs $2.50, its price in yen falls from 500 yen to 250 yen. This fall in price increases the quantity of American-made tennis balls demanded in Japan. That is, American tennis balls are more competitive. 130 Answers to Textbook Questions and Problems b. Consider first the case of floating exchange rates. We know that the position of the LM" curve determines output. Hence, we know that we want to keep the money supply fixed. As shown in Figure 12—18A, we want to use fiscal policy to shift the 18* curve to the left to cause the exchange rate to fall (depreciate). We can do this by reducing government spending or increasing taxes. Figure 12—18 A. Floating exchange rate B. Fixed exchange rates e * LM 6 LM* i , 4 l Exchange rate Exchange rate w 4—— N b.) Y Y Y Y t 1 Income, output Income, output Now suppose that the exchange rate is fixed at some level. If we want to increase competitiveness, we need to reduce the exchange rate; that is, we need to fix it at a lower level. The first step is to devalue the dollar, fixing the exchange ‘ rate at the desired lower level. This increases net exports and tends to increase output, as shown in Figure 12—18B. We can offset this rise in output with contrac- tionary fiscal policy that shifts the [8* curve to the left, as shown in the figure. Chapter 1 2 Aggregate Demand in the Open Economy 131 5. In the text, we assumed that net exports depend only on the exchange rate. This is analo— gous to the usual story in microeconomics in which the demand for any good (in this case, net exports) depends on the price of that good. The “price” of net exports is the exchange rate. However, we also expect that the demand for any good depends on income, and this may be true here as well: as income rises, we want to buy more of all goods, both domestic and imported. Hence, as income rises, imports increase, so net exports fall. Thus, we can write net exports as a function of both the exchange rate and income: NX = NX(e, Y). Figure 12—19 shows the net exports schedule as a function of the exchange rate. As before, the net exports schedule is downward sloping, so an increase in the exchange rate reduces net exports. We have drawn this schedule for a given level of income. If income increases from Y1 to Y2, the net exports schedule shifts inward from NX(Y1) to NXGG). 6 Figure 12—19 / 3 a d.) DD E we NX (Y2) NX Net exports a. Figure 12—20 shows the effect of a fiscal expansion under floating exchange rates. The fiscal expansion (an increase in government expenditure or a cut in taxes) shifts the [8* schedule to the right. But with floating exchange rates, if the LM:k curve does not change, neither does income. Since income does not change, the net—exports schedule remains at its original level NX(Y1). e LM* Figure 12—20 m I Exchange rate N [52 15* Y1 Income, output 132 Answers to Textbook Questions and Problems The final result is that income does not change, and the exchange rate appreciates from 91 to e2. Net exports fall because of the appreciation of the currency. Thus, our answer is the same as that given in Table 12—1. b. Figure 12—21 shows the effect of a fiscal expansion under fixed exchange rates. The fiscal expansion shifts the [8* curve to the right, from IS? to 183‘. As in part (a), for unchanged real balances, this tends to push the exchange rate up. To pre— vent this appreciation, however, the central bank intervenes in currency markets, selling dollars and buying foreign exchange. This increases the money supply and shifts the LM* curve to the right, from LM’f to LM Figure 12-21 Exchange rate Y1—* Y2 Y Income, output Output rises while the exchange rate remains fixed. Despite the unchanged exchange rate, the higher level of income reduces net exports because the net— exports schedule shifts inward. ' Thus, our answer differs from the answer in Table 12—1 only in that under fixed exchange rates, a fiscal expansion reduces the trade balance. 6. We want to consider the effects of a tax cut when the LM:k curve depends on disposable income instead of income: M/P = L[r, Y— T]. Chapter 1 2 Aggregate Demand in the Open Economy 135 The increase in the risk premium raises the interest rate for this country, lower— ing money demand at any given exchange rate and thereby shifting the LM* curve to the right. Intuitively, if real-money balances are fixed, then real—money demand must remain fixed. The decline in money demand caused by the increase in the interest rate must be offset by an increase in money demand caused by an increase in income. The reduction in money demand caused by the increase in the interest rate leads to a higher leVel of income for any given money supply. The higher interest rate also reduces investment spending at any given exchange rate, shifting the [8* curve to the left. As Shown in Figure 12—25, the exchange rate falls and output may either rise or fall depending on the size of the shifts. Figure 12—25 LM* Exchange rate Income, output If money demand is not very sensitive to the interest rate and investment is very sensitive to the interest rate, then IS * will shift by more than LM* and output Will decline. Compared to the traditional Mundell—Fleming model, where LM* is verti- cal, output can fall here, whereas it does not fall in the traditional model but instead always rises. This model gives the more realistic result that both the exchange rate and output are likely to decline when the risk premium rises. California is a small open economy, and we assume that it can print dollar bills. Its exchange rate, however, is fixed with the rest of the United States: one dollar can be exchanged for one dollar. In the Mundell—Fleming model with fixed exchange rates, California cannot use monetary policy to affect output, because this policy is already used to control the exchange rate. Hence, if California wishes to stimulate employment, it should use fiscal policy. In the short run, the import prohibition shifts the IS* curve out. This increases demand for Californian goods and puts upward pressure on the exchange rate. To counteract this, the Californian money supply increases, so the LM”: curve shifts out as well. The new short—run equilibrium is at point K in Figures 12—26(A) and (B). Assuming that we started with the economy producing at its natural rate, the increase in demand for Californian goods tends to raise their prices. This rise in the price level lowers real money balances, shifting the short-run AS curve upward and the LM:k curve inward. Eventually, the Californian economy ends up at point C, with no change in output or the trade balance, but with a higher real exchange rate relative to Washington. 136 Answers to Textbook Questions and Problems A. The Mundell-Fleming Model Figure 12—26 Exchange rate Income, output i B. The Model of Aggregate Supply and Aggregate Demand SRAS Price level Income, output Chapter 1 2 Aggregate Demand in the Open Economy 137 More Problems and Applications to Chapter 12 1. a. Higher taxes shift the IS curve inward. To keep output unchanged, the central bank must increase the money supply, shifting the LM curve to the right. At the new equilibrium (point C in Figure 12—27), the interest rate is lower, the exchange rate has depreciated, and the trade balance has risen. Figure 12—27 A. The IS—LM Model B. Net Capital Outflow LM] r Real interest rate l | : CF(r) Y I ' CF Income, output Net capital outflow l I l I l I | I I I I C. The Market for Foreign Exchange Exchange rate NX(e) NX] NXZ Net expofis 138 Answers to Textbook Questions and Problems b. Restricting the import of foreign cars shifts the NX(e) schedule outward [see panel (0)]. This has no effect on either the IS curve or the LM curve, however, because the CF schedule is unaffected. Hence, output doesn’t change and there is no need for any change in monetary policy. As shown in Figure 12—28, interest rates and the trade balance don’t change, but the exchange rate appreciates. Figure 12—28 A. The IS-LM Model B. Net Capital Outflow Real interest rate CF(r) CF I | | I I I I I | l | I Income, output Net capital outflow l | I | | | C. The Market for Foreign Exchange Exchange rate NX Net exports Chapter 1 2 Aggregate Demand in the Open Economy 139 9 The CF curve becomes flatter, because a small change in the interest rate now has a larger effect on capital flows. As argued in the text, a flatter CF curve makes the IS curve flatter, as well. Figure 12—29 shows the effect of a shift in the LM curve for both a steep and a flat IS curve. It is clear that the flatter the IS curve is, the less effect any change in the money supply has on interest rates. Hence, the Fed has less control over the interest rate When investors are more Willing to substitute foreign and domestic assets. It is clear from Figure 12—29 that the flatter the IS curve is, the greater effect any change in the money supply has on output. Hence, the Fed has more control over output. LM1 LM2 Figure 12—29 Real interest rate n IS steep Income, output 140 Answers to Textbook Questions and Problems 5 i 3. a. No. It is impossible to raise investment Without affecting income or the exchange rate just by using monetary and fiscal policies. Investment can only be increased through a lower interest rate. Regardless of what policy is used to lower the inter— est rate (e. g., expansionary monetary policy and contractionary fiscal policy), net I foreign investment will increase, lowering the exchange rate. r b. Yes. Policymakers can raise investment without affecting income or the exchange rate with a combination of expansionary monetary policy and contractionary fiscal policy, and protection against imports can raise investment without affecting the other variables. Both the monetary expansion and the fiscal contraction would put downward pressure on interest rates and stimulate investment. It is necessary to combine these two policies so that their effects on income exactly offset each other. , The lower interest rates will, as in part (a), increase net capital outflow, which i will put downward pressure on the exchange rate. The protectionist policies, how- i ever, shift the net—exports curve out; this puts countervailing upward pressure on the exchange rate and offsets the effect of the fall in interest rates. Figure 12—30 E shows this combination of policies. LMI LMz CF (r) I I I I I : 152 1S1 | I | | I I _ _ T _ | I | I I I I I I | I I | I I I I .._I_ I— Yly y2 Y CFl CF2 CF I I I Income, output Net capital outflow | CF; 8162 — — — — — — — —— J CF CF NX Net exports Chapter 1 2 Aggregate Demand in the Open Economy 141 c. Yes. Policymakers can raise investment Without affecting income or the exchange rate through a home monetary expansion and fiscal contraction, combined with a lower foreign interest rate either through a foreign monetary expansion or fiscal contraction. The domestic policy lowers the interest rate, stimulating investment. The foreign policy shifts the CF curve inward. Even with lower interest rates, the quantity of capital outflow would be unchanged and there would be no pressure on the exchange rate. This combination of policies is shown in Figure 12—31. Figure 12—31 LMI r r ‘— ' LMZ ['1 E | I I I I r2 - .1 I | I I I I I I I | —’ I 152 15. I CF“) I I Y1) Y2 Y CFII, CF2 CF Income, Output Net capital outflow I | I I I e A CFI 61, 62 — — — — — — ~ -— - NX(e) NX1,NX2 NX Net exports 4, a. Figure 12—32 shows the effect of a fiscal contraction on a large open economy with a fixed exchange rate. The fiscal contraction shifts the IS curve to the left in panel ...
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Chapter 12 - Chapter 1 2 Aggregate Demand in the Open...

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