Question

1. In a monetary model with fixed exchange rates, discuss short run and long run effect of a devaluation on balance of payments.
2. In a Mundell-Fleming model with floating exchange rates and perfect capital mobility, discuss effectiveness of monetary and fiscal policy.

Answer 1

) In the long run there is symmetry between the regime of fixed and flexible exchange rates. Under fixed exchange rates, the exchange rate is exoge- neous and the supply of money endogeneous. Under flexible exchange rates, the supply of money is exogeneous and the exchange rate endogeneous. A devaluation under fixed exchange rates increases the supply of money propor- tionately in the long run; under flexible exchange rates, an increase in the money stock increases the exchange rate proportionately in the long run. An important long-run difference between the two regimes is that under flexible rates the rate of inflation can be varied independently of the rest of the world. Changes in the rate of inflation can be interpreted as changes in the tax on domestic money and they will have systematic effects on the long-run stock of wealth and its composition. Other instruments of fiscal policy can be used in both regimes to alter the stationary state. Because fiscal policy and other real variables have an effect on the long-run demand for money, it is not correct to say that the exchange rate can be explained by monetary factors alone, even in the long run.

If long-run perfect foresight is assumed, the short-run effects and the dynamic path of various disturbances can be inferred from the long-run effects of these disturbances. This result greatly enhances the usefulness of the port- folio balance models of open economies.

The immediate effect of a change in monetary policy is to change the relative price of assets-such as the exchange rate-and the rates of interest. These changes have effects on aggregate demand, prices and output through various channels: (a) by changing the real value of wealth and its distribution across countries, (b) by changing the rates of interest and thereby affecting the rate of investment, and (c) by changing relative commod- ity prices and real wages.

The Mundell-Fleming model shows that the effectiveness of national macroeconomic policy depends on the exchange rate system. This is because in open economy the real exchange rate influence net export and thus income. • Fully flexible exchange rate regimes – very rarely in practice • Mostly often, countries choose exchange rate regimes in which exchange rate is somehow controlled by monetary authorities (managed float, dirty float, fixed exchange rate, pegged exchange rate)

Flexible exchange rates • Here, exchange rate may adjust to the changes in national and foreign economic situation. As a result, the BP curve may move upwards or downwards depending on whether there is a appreciation or depreciation of national currency.

Fiscal policy under flexible exchange rates and perfect capital mobility • Expansionary fiscal policy will shift the IS0 to the right to IS1 that leads to an increase of Y and i. • As a result, domestic interest rate is higher than international one. So there will be an inflow of capital, BP surplus and appreciation of domestic currency. • Appreciation leads to an increase in imports and a fall of exports – IS1 shifts back to IS0 . • Final result: constant Y, constant i. • Conclusion – fiscal policy is ineffective.

Monetary policy under flexible exchange rates and perfect capital mobility • Expansionary monetary policy will shift LM to the right – there is an increase in Y and a fall in i. • As a result there is an outflow of capital (domestic interest rate is lower than international one), balance of payments deficit and a depreciation of domestic currency. Depreciation leads to an increase in exports that shifts IS to IS1 . • Final result: higher Y, constant i. • Conclusion – monetary policy is effective.