Question

Business executives and policymakers are often concerned about the competitiveness of American industry (the ability of U.S. industries to sell their goods profitably in world markets).

1. How would a change in the nominal exchange rate affect competitiveness in the short run when prices are sticky?

2. Suppose you wanted to make domestic industries more competitive but did not want to alter aggregate income. According to the Mundell– Fleming model, what combination of monetary and fiscal policies should you pursue? Use a graph and identify the effects of each policy.

Answer 1

American goods become more competitive because of  the depreciation of the currency.This is due to the fact that depreciation means same price in dollars will fetch less units of foreign currency. This implies American goods become cheaper and foreigners can purchase more of American goods. As for eg,if the exchange rate between Yen and dollars fall from 200yen/dollar to 100 yen/dollar, and if American tennis ball cost $2.50, its price falls from 500 yen to 250 yen.This fall in price increases the demand for American balls in Japan . Thus we see that American tennis balls are competitive.

In a floating exchange rate,LM curve determines output. We want money supply to remain fixed.By using fiscal policy ie reducing government spending or increasing taxes,the IS curve shifts to the left.and exchange rate fall.If the exchange rate is fixed and we want to increase competitiveness , the exchange rate should be fixed at a lower level.This will increase net export and output as seen in the diagram 2. The rise in output can be neutralized with contractionay fiscal policywhich will shift the IS curve to the left as in fig 2.