In the long run a countrys capacity to produce goods

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Unformatted text preview: a fixed- exchange- rate system is the commitment of Page 41 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 the central bank to allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced rate. As long as the Bank stands ready to buy or sell foreign currency at the fixed exchange rate, the money supply adjusts automatically to the necessary level. If the equilibrium exchange rate is greater than the fixed exchange rate (represented by a horizontal line at the fixed exchange rate on the IS*- LM* graph plotted with e on the y- axis and income Y on the x- axis) then the Bank of Canada buys U.S. dollars and thereby increases the money supply, causing LM* to shift right and the exchange rate to decrease. If the equilibrium exchange rate is lower than the fixed exchange rate, then the Bank of Canada sells U.S. dollars for Canadian dollars, decreasing the money supply and shifting LM* left, thereby increasing the exchange rate. The Bank of Canada could continually keep the Canadian dollar below the free- market equilibrium since they can always print money; however this is limited by the willingness of Canadians to tolerate inflation. However, the Bank cannot indefinitely keep the dollar at a price above the free- market equilibrium because it cannot print foreign exchange. Fiscal policy: now we’ll examine how economic policies affect a small open economy with a fixed exchange rate. Suppose the government stimulates domestic spending by increasing government purchases or cutting taxes. This shifts IS* to the right, putting upward pressure on the market exchange rate. Arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to an automatic monetary expansion, shifting LM* to the right. Thus, a fiscal expansion under fixed exchange rates raises aggregate income. Monetary policy: if the central bank tries to increase the money supply, LM* shifts right, arbitrageurs sell domestic currency to the central bank, causing the money supply and LM* curve to return to their original positions. Thus, monetary policy under a fixed exchange rate system is ineffectual. The only monetary policy a country with a fixed exchange rate can conduct is a change in the level at which the e...
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