Question

Suppose you live in a small open economy with flexible prices and a flexible exchange rate.

A) Suppose that the world interest rate rises. What is the effect of this change on the exchange rate and investment?

B) The citizens of your country like to travel abroad. Would the change in the world interest rates affect their cost of spending abroad?

C) Suppose that the introduction of more cash machines (in domestic) reduces demand for money (in domestic). Explain how this affects the trade balance, the real exchange rate, and the nominal exchange rate?

D) A friend tells you that traveling in Singapore is much more expensive now than it used to be. He says “5 years ago, one US dollar bought 1 Singapore dollar, but now 1 US dollar buys only 0.98 Singapore dollars.” Is this friend right or wrong? In your answer, assume that the total inflation over this period was 1% in Singapore and 6% in the U.S.

Answer 1

A) Flexible exchange rate. Flexible exchange rates can be defined as exchange rates determined by global supply and demand of currency. In other words, they are prices of foreign exchange determined by the market, that can rapidly change due to supply and demand, and are not pegged nor controlled by central banks.

In an economy with flexible prices and exchange rate,Higher world interest rates tend to attract foreign exchange, increasing the demand for and value of the home country's currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative values.

When a country has a regime of "flexible exchange rates", it will allow the demand and supply of foreign currency in the exchange rate market to determine the equilibrium value of the exchange rate. So the exchange rate is market determined and its value changes at every moment in time depending on the demand and supply of currency in the market.

Some countries, instead, do not allow the market to determine the value of their currency. Instead they "peg" the value of the foreign exchange rate to a fixed parity, a certain amount of Pesos per Dollar. In this case, we say that a country has a regime of "fixed exchange rates". In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must also commit to defend that parity by being willing to buy (sell) foreign reserves whenever the market demand for foreign currency is greater (smaller) than the supply of foreign currency.

B)The change in world interest rates will surely affects the cost of spending abroad while a person travels to another country,The reason is that the people tends to save more and reduce the level of consumption.They will focus more on savings and investments which will give more returns to the amount they are having with them.

C) The introduction of ATM machines reduces the demand for money. We know that equilibrium in the money market requires that the supply of real balances M/P must equal demand: M/P = L(r*, Y). A fall in money demand means that for unchanged income and interest rates, the right-hand side of this equation falls. Since M and P are both fixed, we know that the left-hand side of this equation cannot adjust to restore equilibrium. We also know that the interest rate is fixed at the level of the world interest rate. This means that income—the only variable that can adjust—must rise in order to increase the demand for money. That is, the LM* curve shifts to the right. Figure 12–13 shows the case with floating exchange rates. Income rises, the exchange rate falls (depreciates), and the trade balance rises

D)His answer is right