This preview has intentionally blurred sections. Sign up to view the full version.View Full Document
Unformatted text preview: PartC 9 Note that since the slope of the BP curve is not speciﬁed, you can use any one that you want.
Here we will use a BP curve which has a smaller slope than the LM curve. The initial equilibrium at “a” is the intersection of LMO, ISO, and BPo. See diagram below.
See diagram below. The temporary equilibrium at “b” is the intersection of LMl with ISO.
Domestic interest rate is lower at the temporary equilibrium. When the domestic central bank
expands money supply, there is excess supply of money initially. Domestic interest rate falls
so that the opportunity cost of holding money decreases. This will then cause an increase in
demand for money, and equilibrium in the money market is maintained. Domestic income is higher at the temporary equilibrium. When domestic interest rate falls,
the cost of borrowing also falls. This encourages domestic investment, which is a component
of total expenditure, and expands output. There is a temporary BOP deﬁcit. The lower domestic interest rate causes a capital outﬂow,
which results in a deterioration of the capital account. The higher domestic income/output
causes consumption to increase, including imported goods and services. The increase in
induced imports results in a deterioration of the current account. Both factors will lead to a
BOP deﬁcit. The BOP deﬁcit causes a domestic currency depreciation. This will cause both the BP and IS
curves to shiﬁ to the right. The depreciation of the domestic currency causes autonomous
exports to increase and autonomous imports to decrease as domestic goods and services
become relatively more competitive, compared with foreign goods and services. This, in turn,
will increase domestic income/output. The ﬁnal equilibrium is at point “c”, where LM‘, [8,,
and BPI intersect. Here are some of the main points. Pros: a. lmposes monetary discipline. The domestic central bank cannot pursue an inflationary policy with
monetary policy. b. Eliminate exchange rate risk (uncertainty). This will promote international trade and economic
growth. c. Prevents the wasteﬁil constant movements in and out of the tradable goods sectors of the economy
by factors of production. Cons: a. Loss of monetary autonomy. This can potentially cause a conﬂict between internal and external
balances. b. Can lead to destabilizing speculation against the domestic currency 0. Disturbances from foreign countries are transmitted to the domestic economy. There is no protection against foreign disturbances. ...
View Full Document
- Spring '11
- International Economics