Question

Suppose a country has a floating exchange rate for its currency and begins in long-run equilibrium. Consider the effect of a temporary rise in real money demand. Use a DD-AA-XX diagram to answer the following (you do not need to show the diagram, but you do need to write in words what happens on it).

(a) Indicate any movement(s) of the curves on your diagram that can be observed as a result of the temporary rise in real money demand. What happens to national income, Y, and the exchange rate, E, as a result? What happens to the current account, and how do you know that?

(b) What should the country do regarding fiscal policy to achieve full-employment national income again in the short run? Indicate any movement(s) of the curves on your diagram that can be observed as a result of the country implementing this fiscal policy. How do the equilibrium exchange rate, E, and national income, Y, levels after implementing this policy compare to their ending equilibrium positions in part (a), and how do they compare to their initial positions prior to the rise in real money demand?

(c) What should the country do regarding fiscal policy to achieve the current account level it started with (the current account level the country had prior to the rise in real money demand)? Indicate any movement(s) of the curves on your diagram that can be observed as a result of the country implementing this fiscal policy. How do the equilibrium exchange rate, E, and national income, Y, levels after implementing this policy compare to their ending equilibrium positions in part (a), and how do they compare to their initial positions prior to the rise in real money demand?

Answer 1

I have tried to answer if you have any doubt please ask in comment.

Answer a/c )

A rise in the money demand leads to excess demand in the money market and a fall in the home interest rate to clear the home money market. This decreases the return on home assets and leads to a rise in the nominal exchange rate to satisfy UIRP (uncovered interest rate parity condition). This is depicted as a rightward shift in AA curve to AA′. Under floating rates, the rise in the nominal exchange rate leads to a rise in the real exchange rate which grounds an increase in the current account. This increase in the current account stimulates aggregate demand for home output and causes home output to rise. The increase in home output causes a rise in imports and thereby decreases the current account balance. This decline in the current account cannot fully offset the increase in the current account which results from the depreciation of the nominal exchange rate. So, the net effect on the current account is an increase. This is depicted with the original equilibrium at 1 and the new equilibrium at 2, which lies above the XX curve. Note that along the XX curve the current account is constant at the level CA = X. Below the XX curve, the current account balance is lower than the level of X and above the XX curve the current account balance is higher than the level of X. Under fixed rates, the home central bank cannot allow the nominal exchange rate to rise. So, they must reverse the increase in the money supply through a contraction of the money supply. Thus, the exchange rate does not change, nor does the current account, nor does output, where the new equilibrium is the same as the original equilibrium. In comparing the effects under the two exchange rate regimes, we see that under floating rates an increase in the home money demand is active in increasing all three variables while it has no effect on any variables under fixed rates.

Ans b) The country will do as explained below regarding fiscal policy to achieve full-employment national income again in the short run. 1. Decrease TAX - A decrease in the home government taxes(fiscal policy) increases the home disposable income which raises home demand for home goods and raises home demand for foreign goods. The first outcome rises home aggregate demand but the second effect (which decreases the current account) decreases home aggregate demand. We shall undertake the first effect controls. So, a decline in taxes raises aggregate demand and the DD curve shifts to the right. The rise in aggregate demand leads to an increase in output, an increase in the demand for real balances, an increase in the home interest rate, and a fall in the nominal exchange rate. Under floating rates, the drop in the nominal exchange rate leads to a fall in the real exchange rate which decreases the current account and falls output, offsetting part of the rise in output from the rise in aggregate demand. Total Output increases because the rise in output due to the rise in aggregate demand is larger than the fall in output due to the lower current account. Overall, the current account falls because of three reasons: 1) the rise in imports induced by an rise in disposable income 2) the decrease in the real exchange rate and 3) the rise in imports induced by the increase in equilibrium output, with the original equilibrium at 1 and the new equilibrium at 2, which lies below the XX curve. Under fixed rates, the central bank must expand the home money supply to prevent the exchange rate from falling. This is depicted as a shift in the AA curve to the right to AA′. Output increases because of the rise in aggregate demand. The current account falls because of two reasons:

1) the rise in imports induced by the rise in disposable income and

2) the rise in imports induced by the increase in equilibrium output.

So comparing we see that the nominal exchange rate falls under floating rates but not under fixed rates. Output increases by less under floating than under fixed rates. The current account decreases both under floating and fixed rates. However, without knowing the actual strengths of the responsiveness of the current account with respect to nominal exchange rate and with respect to home output, we cannot conclude in which case the decrease in the current account will be greater.