Question

A financial crisis is a form of a large, negative, temporary but persistent demand shock in the money market such that costs of borrowing unexpectedly increases for a given level of money supply.

1. Assume flexible exchange rate system. Use the IS-LM-FX model to illustrate the short-run effects of a financial crisis on output, nominal interest rate, exchange rate and investment.

2. Suppose the goal of macro policy is to stabilize output in the short run. What kind of fiscal policy would you recommend in response to the situation in Question 1?

3. Can we replace your fiscal policy in Question 2 with monetary policy? If you answer yes, explain what kind of monetary policy is desirable. If you answer no, explain why.

4. Suppose that the central bank switches to a fixed exchange rate regime before the financial crisis. How will your answer in Question 3 change?

5. Is it possible that this economy remains stuck in lower output than before financial crisis despite efforts to stabilize output? Explain your reasoning. Does your answer depends on the exchange rate policy?

Answer 1

!. a) If investment does not depend on the interest rate, the IS curve is vertical. The IS curve represents the relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. That is, it describes the combinations of income and the interest rate that satisfy the equation Y = C(Y-T) + I(r) + G.

If investment does not depend on the interest rate, then nothing in the IS equation depends on the interest rate; income must adjust to ensure that the quantity of goods produced, Y, equals the quantity of goods demanded, C + I + G. Thus, the IS curve is vertical at this level. Monetary policy has no effect on output, because the IS curve determines Y. Monetary policy can affect only the interest rate. In contrast, fiscal policy is effective: output increases by the full amount that the IS curve shifts.

The LM curve represents the combinations of income and the interest rate at which the money market is in equilibrium. If money demand does not depend on the interest rate, then we can write the LM equation as M/P = L(Y). For any given level of real balances M/P, there is only one level of income at which the money market is in equilibrium. Thus, the LM curve is vertical. Fiscal policy now has no effect on output; it can affect only the interest rate. Monetary policy is effective: a shift in the LM curve increases output by the full amount of the shift.

If money demand does not depend on income, then we can write the LM equation as M/P = L(r). For any given level of real balances M/P, there is only one level of the interest rate at which the money market is in equilibrium. Hence, the LM curve is horizontal. Fiscal policy is very effective: output increases by the full amount that the IS curve shifts. Monetary policy is also effective: an increase in the money supply causes the interest rate to fall, so the LM curve shifts down.

2. Fiscal and monetary policies are frequently used together to restore an economy to full employment output. For example, suppose an economy is experiencing a severe recession. One possible solution would be to engage in expansionary fiscal policy to increase aggregate demand. The central bank can also do its part by engaging in expansionary monetary policy.

On the other hand, we can’t assume that the government and the central bank will always see eye-to-eye on the economy, and it is possible that these two entities work against each other. For example, suppose a government wants to increase output and decrease unemployment by increasing government spending. If the economy is operating on an upward-sloping aggregate supply curve (in other words, if prices are sticky), then this is also going to lead to inflation.

3. To reduce inflationary pressures, the government or monetary authorities will try to reduce the growth of AD. If we use fiscal policy, it will involve higher taxes, lower spending.However, It can be difficult to cut public spending (or increases taxes) for political reasons.

4. Government policies work differently under a system of fixed exchange rates rather than floating rates. Monetary policy can lose its effectiveness whereas fiscal policy can become supereffective. In addition, fixed exchange rates offer another policy option, namely, exchange rate policy. Even though a fixed exchange rate should mean the country keeps the rate fixed, sometimes countries periodically change their fixed rate.