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Problem #4: Fixed vs. Floating Exchange Rate Please answer following questions a

ID: 1113219 • Letter: P

Question

Problem #4: Fixed vs. Floating Exchange Rate

Please answer following questions about a small open economy.

1. If the government wants to implement some fiscal stimulus package (government spending increase or tax decrease), how will the exchange rate be affected in the short-run?

2. Can the government stimulate the output by the fiscal stimulus package? Why?

3. If the constitution also requires the central bank of this economy to stablize the exchange rate fluctuation, how will the central bank react to the fiscal stimulus package? With the central bank’s reaction, will the output be increased?

Explanation / Answer

1) when central bank runs fiscal expansion. It shifts IS curve to the right. It leads to higher output. Higher output implies higher income. With more income people demand more imports. Increase in demand for imports or increase in demand for foreign currency depreciates the exchange rate as there is no change in supply of foreign currency.

2) government spending or decrease in tax rate increases the output which leads to depreciation of currency as discussed in above part. Decrease in depreciation increases the demand for imports as foreign finds domestic currency cheaper. This further shifts the IS curve to the right, resulting in even higher output.

3) when central bank wants to stabilize exchange rate, it sells foreign currency when demand for foreign currency increases to prevent depreciation of the currency. Selling foreign currency in exchange of domestic currency reduces money supply in the market. Thus LM curve shifts to the left. New equilibrium is reached where output is back to original position. Thus output will remain same.

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