Question

In: Economics

Consider an open economy operating under flexible exchange rates. Assuming that both the domestic and foreign...

Consider an open economy operating under flexible exchange rates. Assuming that both the domestic and foreign prices are constant, the economy's short-run behavior can be described by the following IS, LM and interest-parity equations:

Y = C(Y-T)+I(Y,i)+G+NX(Y,Y*,E)
i = i
E = ((1+i)/(1+i*)Ee

The notation is standard except for the policy interest rate which is denoted by i (Moodle doesn't have the over-bar). The expected exchange rate Ee, foreign output Y* and the foreign interest rate i* are taken to be exogenous. Suppose that initially NX=0.
Analyze the effects of an increase in the expected exchange rate (Ee) on the exchange rate (E), net exports (NX), and the domestic output (Y), consumption (C) and investment (I). Briefly describe the economic intuition behind these effects.

Solutions

Expert Solution

Increase in Ee means that spot rate is going up.

Consider a currency pair. Say for eg, USD and INR

Consider 1 USD = 75 INR

Spot rate can be stated as S(INR/USD) = 75

INR is price currency

USD is base currency

Now as Spot rate is going up, say it increases to 80

New spot rate can be stated as S(INR/USD) = 80

That is now, 1 USD can but more INR, i.e. 80 INR

1. So, there is appreciation in USD and depreciation in INR. This will also increase E, i.e. the forward currency exchange rate.

2. As INR depreciated exports in India will increase(cheap for others) and imports will decrease. From USD perspective export will decrease(expensive for others) and imports will increase as dollar appreciated.

NX(INR) = positive

NX(USD) = negative

3. Y (INR) will increase to meet domestic demand, as imports(expensive) decreased.

Y(USD) will decrease because of increasing imports (cheaper)

4. C(INR) will decrease, because of negative sentiments in households about depreciating currency, also known as absorbtion effect.

C(USD) will increase.

5. I(INR) will increase, because imports decreased, now domestic producers should produce more. Also, exports are increasing.

I(USD) will decrease, as exports are decreasing and imports are increasing.


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