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Some economists believe the most important objective

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Unformatted text preview: xchange rate is fixed. A reduction in its official value is a devaluation, and shifts LM* to the right, thus expending net exports and raising aggregate income. An increase in its official value is called a revaluation, shifts LM* to the left, reduces net exports, and lowers aggregate income. Trade policy: suppose the government reduces imports by imposing an import quota or tariff. This increases NX and shifts IS* to the right, raising the exchange rate, so the money supply must rise by shifting LM* to the right. This represents an increase in aggregate income. We consider tariffs levied by foreigners as well. That reduces our net exports so IS* and LM* shift to the left. In contrast to the floating exchange- rate case, Canada Page 42 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 must suffer a recession following the imposition of foreign trade restrictions. Similarly, if we have a fixed exchange rate, we must suffer a recession if world commodity prices change to reduce Canadian net exports. This is one case where it is fortunate Canada had not opted for a fixed exchange rate. The analysis of foreign interest- rate increases under fixed exchange rates is similar to that for trade restrictions imposed by other countries. Higher interest rates lower investment spending by firms, so IS* shifts to the left for this reason, rather than a reduction in net exports. LM* must still shift to the left to keep the exchange rate fixed, and thus Canada suffers a recession following an increase in world interest rates if the exchange rate is fixed. The chart on page 381 is a good summary of the effects of different policies and world events on the exchange rate under the different systems of exchange rates. What is most striking is that all of the results are different under floating and fixed exchange rates. Interest- rate differentials We have assumed that that r = r*, however interest rates differ around the world to some extent. We now examine the causes and effects of international interest- rate differentials. We assumed that r = r* because of the la...
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