Question

Consider the AS-AD model where the economy is not in long-run equilibrium, in particular, assume there is a negative output gap (that is, the economy is in a recession). (a) Describe the adjustment under fixed exchange rates if there is no government intervention. (b) Contrast your answer with that under flexible exchange rates

Answer 1

Case 1 (Fixed Exchange Rate)

In the presence of recession, there will be a decline in demand in the economy. The decline in demand will result in decline in the price level. As the price level declines there will be an increase in the real money supply. For a given level of income, people will have more money in their hand. This will result in increase in the speculative balances of the people. To keep the money market in equilibrium the interest rates will decline.

The decline in the interest rates will result in increased investment by firms as now it will become cheaper for them to borrow for the purchase of machinery and equipment. However, decline in the interest rates will cause investors to pull their money out of the country. The capital outflow will put pressure on the exchange rate to depreciate. Since, there is fixed exchange rate system, so the central bank will intervene in the foreign exchange market by buying the domestic currency and selling the foreign exchange rate.

The decline in the money supply will put pressure on the interest rates to rise. This rise will dampen the earlier impact on increased real money supply. However, the impact of declining money supply will not be able to revert the expansion in the output due to increased investment and in the end the economy will move towards the long-run equilibrium.

Case 2 (Flexible Exchange Rate)

In the presence of recession, there will be a decline in demand in the economy. The decline in demand will result in decline in the price level. As the price level declines there will be an increase in the real money supply. For a given level of income, people will have more money in their hand. This will result in increase in the speculative balances of the people. To keep the money market in equilibrium the interest rates will decline.

The decline in the interest rates will result in increased investment by firms as now it will become cheaper for them to borrow for the purchase of machinery and equipment. On the other hand, decline in the interest rates will cause investors to pull their money out of the country. The capital outflow will put pressure on the exchange rate to depreciate.

However, since the country has flexible exchange rate system, so the exchange rate will be allowed to depreciate. The depreciation of the exchange rate will make the exports of the country more competitive in the world market while making its export more expensive.

So, overall there will be a double push to the economy to come out of the recession. In other words, compared to the fixed exchange rate system, economy under the flexible exchange rate system will come out of recession early and will reach the long-run equilibrium more quickly.