Question

What are the effects of temporary monetary and fiscal policies under flexible vs. fixed exchange rate systems in the short run? Show using both the FX and Money Market graphs and the AA-DDmodel

Answer 1

1.1. Fiscal Policy under Fixed Exchange Rates

1. Fiscal stimulus (increase spending; lower taxes increases aggregate demand (shifts DD to right).

2. But this causes initial appreciation (fall in E); equil is at 2.

3. To protect the peg, CB must buy foreign assets with home currency. This increases the domestic money supply, which moves economy to final equil 3 (higher output)

4. Fiscal policy is potent because it causes both the DD and the AA schedules to shift Fiscal Policy under Fixed Exchange Rates.

Fiscal policy is more effective under fixed exchange rates

1.2. Effects of of Fixed Exchange Rates

• With a fixed exchange rate you give up on an independent monetary policy
• So you cannot use monetary policy to target domestic inflation or to try to smooth out the      domestic business cycle
• The only hope for independent monetary policy is exchange controls to prevent traders buying or selling domestic currency
• But exchange controls reduce trade and foreign direct investment, and
• Expansionary monetary policy causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate system in the short run.
• Contractionary monetary policy causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short run.
• Expansionary fiscal policy causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
• Contractionary fiscal policy causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.

2.0. Money Market graphs and the AA-DDmodel

The AA-DD model represents a synthesis of the three previous market models: the foreign exchange (Forex) market, the money market, and the goods and services market. In a sense, there is really very little new information presented here. Instead, the chapter provides a graphical approach to integrate the results from the three models and to show their interconnectedness. However, because so much is going on simultaneously, working with the AA-DD model can be quite challenging. The AA-DD model is described with a diagram consisting of two curves (or lines): an AA curve representing asset market equilibriums derived from the money market and foreign exchange markets and a DD curve representing goods market (or demand) equilibriums. The intersection of the two curves identifies a market equilibrium in which each of the three markets is simultaneously in equilibrium. Thus we refer to this equilibrium as a super equilibrium.

AA Curve Effects from a Decrease in the Money Supply

The AA curve depicts the relationship between changes in one exogenous variable and one endogenous variable within the asset market model. The exogenous variable changed is gross national product (GNP). The endogenous variable affected is the exchange rate. At all points along the AA curve, it is assumed that all other exogenous variables remain fixed at their original values.