The exchange rate as an automatic stabilizer Consider an economy that suffers a

Question

The exchange rate as an automatic stabilizer Consider an economy that suffers a fall in business confidence (which tends to reduce investment). Let UIP stand for the uncovered interest parity condition. Suppose the economy has a flexible exchange rate. In an IS-LM-UIP diagram, show the short-run effect of the fall n business confidence on output, the interest rate, and he exchange rate. How does the change in the exchange rate, by itself, tend to affect output? Does the change in the exchange rate dampen (make smaller) or amplify (make larger) the effect of the fall in business confidence on output? Suppose instead the economy has a fixed exchange rate. In an IS-LM-UIP diagram, show how the economy responds to the fall in business confidence. What must happen to the money supply in order to maintain the fixed exchange rate? How does the effect on output in this economy, with fixed exchange rates, compare to the effect you found for the economy in part (a), with flexible exchange rates? Explain how the exchange rate acts as an automatic stabilizer in an economy with flexible exchange rates.

Explanation / Answer

a)The adverse shift will push the nominal interest rate downward. This impact will depreciate the nominal exchange rate. However, we know that a depreciation leads to an improvement in the trade balance, that is an increase in the demand for domestic goods. This will shift the IS curve to the right, from IS' to IS''(upwards) . The exchange rate here acts by dampening the impact of a decrease in business confidence on Output . Without the effect of the depreciation, output would have dropped to a much lower level.

b)In this situation, after the initial shift of the IS curve to IS', the downward pressure on the nominal interest rate cannot be compensated by a depreciation of the exchange rate. The central bank has to intervene to increase the nominal exchange rate at the initial level in order for the exchange rate to remain fixed. This can be obtained by a reduction in the money supply, a shift of the LM curve to the left (LM'). The new equilibrium is at a point where the domestic interest rate is the same as before, the exchange rate is fixed and output is lower .Compared to the flexible exchange rate case, the reduction in output is much more in the fixed exchange rate regime.

c). The difference between the reduction in output in the flexible and the fixed exchange rate regimes is due to the fact that in the former the exchange rate acts as an automatic stabilizer.Actually, the exchange rate is a price that, if let free to adjust, it realigns automatically demand and supply. When the exchange rate depreciates because of a weak demand for investments and a lower nominal interest rate, the depreciation activates an additional demand for domestic goods that compensates for the weak demand for investments and keeps output from falling too much. In a fixed exchange rate this automatic stabilizing effect is not only missing, but the attempt to keep the exchange rate from adjusting resolves in a reduction in money supply which magnifies the impacts of a weakening demand on output

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