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DIG DEEPER MyEconLab Visit www.myeconlab.com to complete al Dig Deeper problems and get instant feedback. 6. Fixed exchange rates and foreign macroeconomic policy Consider a fixed exchange rate system, in which a group of countries (called follower countries) peg their currencies to the currency of one country (called the leader country). Because the currency of the leader country is not fixed against the currencies of countries outside the fixed exchange rate system, the leader country can conduct monetary policy as it wishes. For this problem, consider the domestic country to be a follower country and the foreign country to be the leader country. a. How does an increase in interest rates in the leader country affect the interest rate and output in the follower country? b. How does the increase in leader country interest rates change the composition of output in the follower country? Assume the follower country does not change fiscal policy. c. Can the follower country use fiscal policy to offset the ef- fects of the leader country's reduction in interest rates and leave domestic output unchanged? When might such a fis- cal policy be desirable? d. Fiscal policy involves changing government spending or Design a fiscal policy mix that leaves con- sumption and domestic output unchanged when the leader untry increases interest rates. What component of out- changing taxes. I put is changed?Explanation / Answer
In case of fixed exchange rate system in which some countries are followers to the leader country which is not linked to other countries in fixed exchange rate, the followng countries have to adjust the exchange ration with the leader currency. In this context the answer to the questions can be answered as follows.
Answer a
If the interest rate of the leader country to which other currencies are pegged, the exchange rate of the leader currency with respect to other currencies of the world will rise. Since, the following countries are pegged, the exchange rate of these currencies will also rise in proportion. With the interest rate rising, there would be more supply of money in the market which will lead to more employment. If the interest rate falls, it will have its impact on the currency in terms of its devaluation in parity with the leading currency. But the following countries must have a balance of exports and imports along with the debts.
Answer b
With the interest rate rising as a follow up of the leading currency, there would be rise in investment by the entrepreneurs in more exports. This may boost up the output and accordingly lead to change in composition of output. Fiscal policy remaining unchanged means the government will not change the saving investment behaviour. But, with interest rate rising the consumption and investment behaviour of the household and entrepreneurs may change. This may have impact on the composition of output.
Answer c
Pegging does not mean compromising the national interest. Hence, if a country is pegged to a dominant currency, it is pegged for a high and a low value of its currency. As the comparative cost advantages vary and they depend upon the varying parameters of resources, the following country may resort to fiscal policies in order to outweigh the leader's policy to safeguard the interest. This may happen when the leading country lowers the interest rate and resulting devaluation of its currency. The following country may not like to devalue its currency.
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