1 A) Explain, briefly and clearly, why a country that chooses to fix its exchang
ID: 1151249 • Letter: 1
Question
1 A) Explain, briefly and clearly, why a country that chooses to fix its exchange rate forgoes domestic monetary policy. Use any combination of illustrations or explanation that conveys a clear, concise argument.
B) Describe (rather than simply name) the biggest risk debt-financed expansionary fiscal policy presents in an economy in the short-run.
C) How might a central bank mitigate the short-run risk you described in 1B? Explain.
D) Consider two open economies – one large and one relatively small – both with floating exchange rate regimes. Describe the opposing effects of contractionary monetary policy in the large economy on aggregate demand in the small economy.
Explanation / Answer
Using the AA-DD model, several important relationships between key economic variables are shown:
Connections
The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The two main levers the government controls are monetary policy (changes in the money supply) and fiscal policy (changes in the government budget). In this chapter, the AA-DD model is applied to understand government policy effects in the context of a floating exchange rate system. In Chapter 12 "Policy Effects with Fixed Exchange Rates", we’ll revisit these same government policies in the context of a fixed exchange rate system.
It is important to recognize that these results are what “would” happen under the full set of assumptions that describe the AA-DD model. These effects may or may not happen in reality. Despite this problem, the model surely captures some of the simple cause-and-effect relationships and therefore helps us to understand the broader implications of policy changes. Thus even if in reality many more elements not described in the model may act to influence the key endogenous variables, the AA-DD model at least gives a more complete picture of some of the expected tendencies.
Step 1: When the money supply increases, real money supply will exceed real money demand in the economy. Since households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid nonmoney assets. This raises the supply of long-term deposits and the amount of funds available for banks to loan. More money to lend will lower average U.S. interest rates, which in turn will result in a lower U.S. rate of return in the Forex market. Since RoR$ < ROR£ now, there will be an immediate increase in the demand for foreign British currency, thus causing an appreciation of the pound and a depreciation of the U.S. dollar. Thus the exchange rate (E$/£) rises. This change is represented by the movement from point Fto G on the AA-DD diagram. The AA curve has shifted up to reflect the new set of asset market equilbria corresponding to the higher U.S. money supply. Since the money market and foreign exchange (Forex) markets adjust very swiftly to the money supply change, the economy will not remain off the new A?A? curve for very long.
Step 2: Now that the exchange rate has risen to E$/£1?, the real exchange has also increased. This implies foreign goods and services are relatively more expensive while U.S. G&S are relatively cheaper. This will raise demand for U.S. exports, curtail demand for U.S. imports, and result in an increase in current account and, thereby, aggregate demand. Because aggregate demand exceeds aggregate supply, inventories will begin to fall, stimulating an increase in production and thus GNP. This is represented by a rightward shift from point G.
Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom, and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate (E$/£). This moves the economy downward, back to the A?A? curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the A?A? curve, as shown in the figure.
Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram.
Step 5: The equilibrium at H lies to the northeast of F along the original DD curve. As shown in Chapter 9 "The AA-DD Model", Section 9.8 "AA-DD and the Current Account Balance", the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise.
Contractionary Monetary Policy
Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.
The quick effects, however, are as follows. U.S. contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate, E$/£, implying an appreciation of the U.S. dollar and a decrease in the current account balance.
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