Macro.Week12.2008 - II - 12/1 FILL IN COURSE EVALUATIONS ON...

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II - 12/1 FILL IN COURSE EVALUATIONS ON INTRANET Consider monetary policy in a world of floating exchange rates So far, we have discussed how government might use monetary policy: 1. Expansionary monetary policy: Government buys bonds domestically through Bank of Canada. Links: Because Investment rises when r falls, we get expansion of AE, and hence AD shifts to the right:
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II – 12/2 Two modifications, one small, one large. First, the small one, which we already discussed. As GDP rises, this increases the demand for liquidity, and raises r back up a bit, so effect is a bit smaller than we might imagine To see this, reconsider MS-MD diagram: Second the big modification! The fall in r has a significant effect on the foreign currency market This is very important in Canada, since we are closely linked to U.S. capital markets.
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II – 12/3 So story goes like this: MS up r down I up AE up AD shifts right Y up but also r down so foreigners buy less Canadian bonds, and Canadians buy more foreign bonds so less demand for Canadian currency and more supply (on international currency markets) This means that E C/US falls (depreciates) So X up and IM down AD shifts right again Y up Monetary policy is reinforced
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II – 12/4 Opposite story for contractionary monetary policy: MS down r up I down AE down AD left Y down but also r up so foreigners buy more Canadian bonds, and Canadians buy less foreign bonds so more demand for Canadian currency and less supply (on international currency markets) This means that E C/US rises (appreciates) So X down and IM up AD shifts left again Y down Monetary policy is reinforced
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II – 12/5 Note that this effect is larger if domestic financial capital markets are very closely linked to foreign financial capital markets. If linked, then change in r has very large effect on demand and supply for currency internationally: To see effect, look at L diagram: 1. Expansionary monetary policy 2. Contractionary monetary policy
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II – 12/6 Now, what about fiscal policy? Earlier we learned that an increase in G increased AE, which shifts AD to the right by (multiplier) X (change in G) = M G Now we have to add two modifications. The first is crowding out, which we have already discussed: The increase in GDP increases demand for liquidity, pushing up r and crowding out some I
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II – 12/7 The second modification is, in Canada, more important. The rise in r, which leads to crowding out, ALSO AFFECTS THE EXCHANGE RATE The increase in r that is part of crowding out causes foreigners to want more Canadian bonds (increases the demand for Canadian dollars to buy those bonds) and also causes Canadians to buy fewer foreign bonds (reduces the supply of Canadian dollars) This increases the E C/US , and this reduces exports and increases imports, counteracting the effect of the expansionary fiscal policy This can be shown in a schematic: In Canada, where the capital markets are closely linked to the US, this is a big thing, and the impact of fiscal policy can be virtually zero.
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II – 12/8 To see this, look at L – MS diagram: Opposite is true for contractionary fiscal policy: Schematic:
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This note was uploaded on 06/13/2011 for the course ECON A06 taught by Professor Mk during the Spring '11 term at University of Toronto- Toronto.

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Macro.Week12.2008 - II - 12/1 FILL IN COURSE EVALUATIONS ON...

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