week7 - Output and the Exchange Rate in the Short Run...

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Unformatted text preview: Output and the Exchange Rate in the Short Run (cont.) Viktoria Hnatkovska week 7 1 Permanent Changes in Monetary and Fiscal Policy & Permanent policy changes are assumed to modify people&s expectations about exchange rates in the long run. & Changes in expectations have a major inuence on the exchange rate prevailing in the short-run. & Therefore, the e/ects of permanent policy shifts will di/er from those of temporary policy changes. & Next we will look at the e/ects of permanent changes in the scal and monetary policy, in both short-run and long-run. & Assume that the economy starts at the long-run equilibrium (full-employment) with the exchange rate at its long-run level and no changes in the exchange rate expected. & This implies that R = R initially. 2 Permanent Changes in Monetary Policy & A permanent increase in M s lowers interest rates in the short run. & Unlike in the analysis of temporary M s changes, a permanent change in M s makes people expect future depreciation of the domestic currency. & This increases the expected rate of return on foreign currency deposits. & The domestic currency depreciates more than (E rises more than) the case when expecta- tions are constant (Chapter 14 results). & The AA curve shifts up (right) more than the case when expectations are held constant. 3 Permanent Changes in Monetary Policy & Point 1 is the initial full-employment equilibrium & Point 2 is the new short-run equilibrium & Point 3 is the equilibrium that might prevail after a temporary increase in M s : 4 Adjustment to a permanent increase in the money supply & Permanent increase in M s is not reversed over time by the central bank. So economy will be a/ected over time. & At the short-run equilibrium (point 2 on the graph above), employment and hours are above their full-employment levels. So there is a tendency for wages to rise over time. & With strong demand of goods and services and with increasing wages, producers have an incentive to raise prices over time. & Both higher wages and higher output prices are re&ected in a higher level of average prices. & In Chapter 14 we saw that with no money illusion, changes in M s had no lasting e/ect on output, relative prices, or interest rates. & Over time the in&ationary pressure of M s " pushes prices to their higher long-run equilib- rium level and returns the economy back to its full-employment level. & How does the adjustment back to full employment equilibrium take place? 5 Long-run adjustment back to full employment & At point 2, output is above its full employment level, so P starts to rise....
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week7 - Output and the Exchange Rate in the Short Run...

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