Question

Explain about the trilemma in economics and overshooting. Also what affects the home market, forex market?

Answer 1

Answer)

OVERSHOOTING

Adjustment to a Permanent Increase in the Money Supply
At the short-run equilibrium, shown as point 2 , output is above its Full-employment level and labor and machines are working overtime. Upward pressure on the price level develops as workers demand higher wages and producers raise prices to cover their increasing production costs). An increase in the money supply must eventually cause all money prices to rise in proportion, it has no lasting effect on output, relative prices, or interest rates. Over time, the inflationary Pressure that follows a permanent money supply expansion pushes the price level to its new long-run value and returns the economy to full employment.

Whenever output is greater than its full-employment level, Yf, and productive factors are working overtime, the price level P is rising to keep up with rising production costs. Although the DD and AA schedules are drawn for a constant price level P, we have seen how increases in P cause the schedules to shift. A rise in P makes domestic goods more expensive relative to foreign goods, discouraging exports and encouraging imports. A rising domestic price level therefore causes DD¹ to shift to the left over time. Because a rising price level steadily reduces the real money supply over time, AA² also travel to the left as prices rise.

(The DD and AA schedules stop shifting only when they intersect at the full employment output level Yf; as long as output differs from Yf, the price level will change and the two schedules will continue to shift The schedules' final positions are shown as DD² and AA³. At point 3, their intersection, the exchange rate E and the price level, P, have risen in proportion to the increase in the money supply, as required by the long-run neutrality of money. AA² does not shift all the way back to its original position because Ee is permanently higher after a permanent increase in the money supply: It too has risen by the same percentage as Ms. ) Notice that along the adjustment path between the initial short run equilibrium(point 2) and the long-run equilibrium (point 3), the domestic currency actually appreciates (from E² to E³) following its initial sharp depreciation (from E¹ to E²) This exchange rate behavior is an example of the OVERSHOOTING phenomenon , in which the exchange rates initial response to some change is greater than it's long-run response.

TRILEMMA

Policymakers in an open economy face a monetary trilemma in choosing the currency arrangements that best enable them to attain their internal and external balance goals. The sacrifice illustrates the impossibility of a country's having more than two items from the following list -

1) Exchange Rate Stability

2) Monetary policy oriented toward domestic goals

3) Freedom of international capital movements

Because this list contains properties of an international monetary system that most economists would regard as desirable in themselves, the need to choose only two is a trilemma for policy regimes. It is a trilemma rather than a dilemma because the available options are three - 1and 2 , 1 and 3 , 2 and 3. The figure shows the three desirable properties of an international monetary regime as the vertices of a triangle. Countries with fixed exchange rates that allow free cross-border capital mobility sacrifice item 2 above, a domestically oriented monetary policy. On the other hand, if a country with a fixed exchange rate restricts international financial flows so that the interest parity condition, R = R*, does not need to hold true (thereby sacrificing item 3 above), it is still able to change the home interest rate so as to influence the domestic economy (thereby preserving item 2). In this way, for example, the coin try might be able to reduce domestic overheating (getting closer to internal balance by raising the interest rate) without causing a fall in its exports (preventing a potential departure from external balance due to an appreciation of its currency). Finally, a country that has a floating exchange rate (and thus gives up item I above) can use monetary policy to steer the economy even though financial flows across its borders are free. But the exchange rate might become quite unpredictable as a result, complicating the economic planning of importers and exporters.

Only two can be reached simultaneously. Each edge of the triangle represent a policy regime consistent with the two properties shown at the Edge's end points.

Of course, the trilemma does not imply that intermediate regimes are impossible, only that they will require the policymaker to trade off between different objectives.

(If you have any doubts please comment...)