Question

a) Explain the advantages and disadvantages of exchange rate targeting.

b) Supposing that Malaysia is adopting the fixed exchange rate system. By assuming that the Purchasing Power Parity holds, and based on IS-LM and AD-AS diagrams, explain what would happen to relative prices if the government increases or decreases its expenditure.

c) Differentiate between a fixed and flexible exchange rate.

d) Despite the disadvantages, why is fixed exchange rate preferred?

Answer 1

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Question:

Answer:

IS-LM Diagram:

The IS-LM model presents as a graph that shows the intersection of goods and the money market. The IS stands for Investment and Savings. The LM stands for Liquidity and Money. The IS-LM model attempts to explain a way to keep the economy in balance through an equilibrium of money supply versus interest rates. IS affected when, the government increases or decreases its expenditure. When the government increases its expenditure then IS curve shift rightward with increasing GDP and interest rate and vice-versa. Here LM curve will not change because we are talking about government spending not money supply so, money supply will unchanged.

AD-AS Curve:

It is a macroeconomic concept its talk about the relation between AD-AS with the price level and GDP level in short and long run. AD (Aggregate Demand) is the total demand of goods and service by the consumers during the specific period at different price level. AS (Aggregate Supply) is the total amount of real goods and services that all domestic firms are willing and able to supply at each given price level. AD is affected by consumption, Government expenditure, investment, net export etc and AS affected by labor cost, capacity, efficiency etc.When AD increase more then its increase the total output/GDP.

Exchange Rate Targeting:

It is a process by which a central bank direct intervene in the exchange rate market to maintain the favorable exchange rate. Some countries have fixed exchange rate regimes where the central bank use their net international reserves to alter the supply of currency to keep it fixed or maintain it at a particular rate with another currency.

a). Answer:

Advantages and disadvantages of exchange rate targeting:

Advantage: We know that it is a process by which a central bank direct intervene in the exchange rate market to maintain the favorable exchange rate.Here a central bank change the exchange rate accordingly. When a country want to increase export then decreased the exchange rate with other currency. It is helpful to the poor and underdeveloping nation those are mostly depend upon the advanced country for the capital, goods, services or technologies so, their trade is mostly highly imbalanced. So, here, central bank try to maintain the exchange rate in own favor.

disadvantages: Other side there is some disadvantages of it. Because here, the central bank use their net international reserves to alter the supply of currency to keep it fixed or maintain it at a particular rate with another currency and it is very costly and not always presence to use. It is some time become the reason of dispute between two nation like, US-China dispute. We also know world economy is very dynamic in nature so, to reset accordingly is not easy always.

b). Answer:

As per the question, Supposing that Malaysia is adopting the fixed exchange rate system and  the government increases or decreases its expenditure so its definitely affect the relative price level. Here, government change the expenditure so it is directly related to government's fiscal policy. Government spending affect the saving, investment and AD also.

We have seen basic about the IS-LM and AD-AD. When the government will increase the expenditure then IS curve shift rightward with increasing GDP and interest rate and vice-versa. Here LM curve will not change because we are talking about government spending not money supply so, money supply will unchanged and vice versa.

We have seen in the AD-AS curve analysis above that when the government will increase the expenditure then it will increase AD and it will shift AD curve rightward. We also know that AD is affected by consumption, Government expenditure, investment, net export etc and AS affected by labor cost, capacity, efficiency etc.When AD increase more then its increase the total output/GDP. When government will reduced the expenditure then it will negatively affect the AD , price and GDP.

c). Answer:

Fixed and flexible exchange rate both are totally different. In fixed exchange rate the government and central bank direct intervene in the exchange rate market to maintain the favorable exchange rate. Some countries have fixed exchange rate regimes where the central bank use their net international reserves to alter the supply of currency to keep it fixed or maintain it at a particular rate with another currency. Other side in flexible exchange rate the central bank or other monetary authorities do not intervene in the exchange rate market and the exchange rate is determine by the market mechanism (demand and supply). Market automatic reset and adjust the exchange rate without intervention of the central bank or other monetary authorities.

d). Answer:

Despite the disadvantages, fixed exchange rate preferred for the the poor and under-developing nation. When a country want to increase export then decreased the exchange rate with other currency. It is helpful to the poor and underdeveloping nation those are mostly depend upon the advanced country for the capital, goods, services or technologies so, their trade is mostly highly imbalanced. So, here, central bank try to maintain the exchange rate in own favor. So, it is depend upon the current situation of the nation and its economy.

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