Global Economy II – Spring 2014/15 Miguel Lebre de Freitas Sharmin Sazedj Carolina Salvaterra
Problem set 9 – Fixed Exchange Rates
Keywords:
Problems
9.1. [AA-DD]. Consider an open economy maintaining a fixed exchange rate. The price level is initially equal to the foreign price level (PP* 1), and the nominal exchange rate is equal to 1. The interest rate is initially equal to the foreign interest rate, i*=0.1. The home money demand is given by mD Y 10i. The goods market equilibrium is described by the following expression: Y 2
ATB
, where
5 1
*
P
TB eP . Initially, A 50, and the full employment output is Yf 100.
a) Find out the expression of the DD curve.
b) Admitting that the economy is initially in full employment, find out the (endogenous) money supply as well as the implied AA curve.
c) (Fiscal expansion – short run) Suppose that there is a fiscal expansion, so that A 52.5. Describe the implied short term equilibrium, namely: c1) The new DD schedule; c2) the output level; c3) the money supply; c4) the AA schedule. C5) the TB. Explain the mechanism that drives the AA schedule to the right.
d) (Fiscal expansion – long run) Assuming that the fiscal expansion was permanent, how would the economy adjust in the long run? In particular, describe the long term: d1) Price level; d2) DD schedule; d3) Real exchange rate; (d4) TB; (d5) Money supply; (d6) AA schedule. Explain why did the money supply changed during the adjustment to the long run. In the long run, prices and money evolved proportionally?
e) (Devaluation– short run, long run) Departing from b), examine now the implications of a devaluation, from e=1 to e=2. In particular, describe the short term equilibrium (AA-DD schedules, money supply, real exchange rate, trade balance) and the long run equilibrium (same). Explain carefully the adjustment in the money market. In the long run, was there any real effect?
9.2. [Self-fulfilling crisis]. Consider an open economy with sticky prices maintaining a fixed exchange rate. The price level is initially equal to the foreign price level (PP* 1), and the nominal exchange rate is equal to 1. The interest rate is initially equal to the foreign interest rate, i*=0.1. The home money demand is given by mDY 10i. The goods market equilibrium is described by the following
expression: Y2
ATB
, where
5 1
*
P
TB eP . Initially, A45, and the full employment output is Yf 100.
a) Assuming that the peg is credible, compute the AA and DD curves for this economy and describe the initial equilibrium. How much will be domestic credit?
b) In the following, assume that the government considers the automatic adjustment process to the long run as acceptable from the social point of view.
In the absence of government actions or changes in expectations, how will the economy evolve along time? Describe the long run equilibrium of this economy (price level, output, real exchange rate, trade balance, money supply, etc.).
c) In alternative, could the authorities drive the economy immediately to full employment through a devaluation? How much should the new exchange rate be? What would happen to the money supply? Describe this eventual equilibrium using the AA-DD diagram.
d) Suppose that agents believe the government will devalue the currency as found in c), but the government intends to keep the peg. Describe the short run equilibrium in this case. In particular, find out the money supply and the interest rate that have to hold in order for the peg to be maintained.
e) Knowing that agents (households, firms, banks, government) in this economy were highly leveraged, would the government be able to credibly commit with the peg, after the change in expectations? Explain how this model can illustrate a case with multiple equilibria.
9.3. Consider an open economy with a fixed exchange rate and sticky prices where initially Pe5. The foreign price level is P* 1. The home money demand is given by mY i, and full employment output is Yf 100. The interest rate parity holds instantaneously and the foreign interest rate is equal to i*=0.2. The goods market equilibrium is described by the following expressionY4
ATB
, where
5 1
*
P
TB eP . Initially, A20.
a) Assume that the peg is credible. Find the implied money supply and the corresponding AA and DD curves for this economy.
b) In the absence of policy actions, how would the adjustment to the long run occur? Describe the adjustment using the AA-DD, and quantify the long term values of prices, money, and trade balance. Explain carefully the implications for the central bank balance sheet.
c) Describe the Swan diagram of this economy, choosing the exchange rate and the level of domestic absorption for the two axes.
d) Could fiscal policy be used to achieve the full employment? Describe, quantifying, the required increase in domestic absorption. Explain the
adjustment in the AA-DD diagram and quantify the impact on the trade balance and on the money supply.
e) Describe the adjustment of the economy to (c) in the Swan diagram.
f) Imagine the government wanted to devalue the currency to reach immediately full employment. How much should the new exchange rate be? Quantify and explain what would happen to: the trade balance; money supply; reserves.
Describe this adjustment using the AA-DD diagram andin the Swan diagram.
g) Now assume the government wants to keep the peg but agents believe in the devaluation referred to in e). How should the monetary authorities react?
Discus the likelihood of the policy to succeed in that case (max 5 lines).
h) Returning to (a), suppose the foreign central bank decided to increase the interest rate on a permanent basis to i*=0.25. Was this good news or bad news to the domestic economy? Show the adjustment in a graph and quantify.
