Question

Suppose that Mexico experiences a shock that exogenously increases money demand. (Note, this is an exogenous shift in money demand, not an endogenous response to some other variable in the money demand function.) Study how this shock can cause a recession, and how policy makers can respond to it. Assume a flexible exchange rate.

For the scenarios below (a and b), show the effect of the money demand shock and the policy response to it. You should include the IS/LM, money market, and FOREX market diagrams. Please label curves as follows:

- Point A: initial equilibrium  

-Point B: effect of the money demand shock without a policy response

- Point C: effect of the money demand shock with a policy response.

- You must state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, CA.

For simplicity, assume here that MPCF = 0. This implies that the trade balance and current account are just a function of the real exchange rate and not income.

Suppose that monetary policy is used as stabilization policy, which maintains the level of output at its initial value despite the money demand shock. (5p)

Now suppose that instead, a fiscal policy of a tax cut is used as stabilization policy, keeping the level of output fixed at its initial value. (No monetary policy used here). (5p)

Answer 1

Exogenous Money Demand Shock and Policy Responses

In the below Figure 1 and Figure 2(below part) both

“Panel a” shows the Money Market: X-axis shows the quantity of money and Y-axis shows the nominal interest rates. Initially the money demand curve MD1 intersect the money supply curve MS1 at equilibrium point A. Here equilibrium interest rates are “iA” and equilibrium quantity of money is Qm.

“Panel b” shows IS-LM framework: X-axis shows the income/output and Y-axis shows the nominal interest rates. Initially the IS1 and LM1 curve intersects at equilibrium point A, where equilibrium interest rates are “iA” and the equilibrium income is YA. Let this be the potential level of output.

“Panel c” shows the foreign exchange market: Here X-axis shows the quantity of domestic currency demanded and supplied (Dollars) and the Y-axis shows the foreign price of dollars, which is the real exchange rate. The Dollar demand curve D$1 intersects the Dollar supply curve S$1 at equilibrium point A, where equilibrium quantity of dollars is QA and equilibrium exchange rate is EA.

Effect of Exogenous Increase in Demand for Money

In the below Figure 1 and Figure 2(below part) both, an exogenous demand for money effects each market in the following way:

“Panel a”: Money demand curve shifts upwards from MD1 to MD2. With and unchanged money supply, the interest rates rises from “iA” to “iB”. The money market equilibrium moves to point B. Higher interest rates means, the cost of borrowing is high, thus the households and business firms are induced to reduce their consumption ( C ) and investment ( I ), that lowers the aggregate output in the economy.

“Panel b”: At any level of income and money supply, interest rates are higher that shifts the LM curve upwards from LM1 to LM2. This causes the economy to face a recessionary gap as output levels fall to YB, which is less than the potential level YA. Here the new equilibrium is at Point B.

“Panel c”: Higher interest rate means, the returns on Dollar deposits are higher. Foreign investors demand more dollars which shifts the demand curve of dollars from D$(1) to D$(2). The domestic investors too prefer to hold more of dollars than the foreign currency. This reduces the supply of dollars in the Forex market, which causes the supply curve of dollars to shift upwards from S$(1) to S$(2). The quantity of dollars remains intact to QA, but the foreign price of dollars increase from EA to EB, at the new equilibrium point B. Thus, there is an exchange rate appreciation. With a stronger dollar, domestically produced goods and services become expensive, making US exports expensive. This results into a fall in US exports and an overall fall in Net Exports (NX).

a. Effects of Monetary Policy: (Refer to all the panels in Figure 1)

In order to stabilize the economy, an expansionary monetary policy which increases the money supply, shifts the money supply curve rightwards from MS1 to MS2. The money market equilibrium moves to point C (Panel A). Increased money supply causes the LM curve shifts rightwards back from LM2 to LM1. Here the interest rate falls back to “iA” and the output is maintained to its initial levels YA (Panel B). With lower interest rates, the demand for dollars falls and the supply of dollars increases, that shifts the supply and demand curve back to their original leaves, which causes currency depreciation from EB back to EA. (Panel C)A weaker currency means cheaper US exports and thus increases in demand for US exports leading to an increase in its Net Exports.

b. Effects of Monetary Policy: (Refer to all the panels in Figure 2 - below part)

In order to stabilize the economy, an expansionary fiscal policy of tax cut, means an increases in the disposable income. Suppose the economy is at point B after the money demand shock. An increase in income causes the money demand to increase further from MD2 to MD3. Interest rates rise to “iC”. Money market equilibrium moves to Point C (Panel a). This causes the IS curve to shift downwards to IS2. The both goods market and money market moves to equilibrium at point C, where interest rates rises, however the output gets stabilized back to YA(Panel b). Rising interest rates further increases the demand for dollars by foreign investors and reduces the supply by US investors, causing a further increase in the foreign price of dollars. Exchange rate appreciates further to Ec, as Dollar Demand Curve shifts to D$(3) and Dollar supply shifts to S$(3).