Question

4). Using IS-LM, what happens to C, I, G, NX, AD, and r if the value of the dollar increases? What happens if US prices increase faster than foreign prices?

Answer 1

Goods market:

• Equilibrium in the goods market:Y = C(Y-T) + I(Y,r) + G - eIM(Y,e) + X(Y*,e)

• Net exports:NX(Y,Y*,e) = X(Y*,e)- eIM(Y,e)

• Equilibrium in the goods market:Y = C(Y-T) + I(Y,r) + G + NX(Y,Y*,e)

• Real vs nominal exchange rate: e = EP*/P. Assume domestic and foreign prices are fixed (at P*= P) so e = E

.• Assume inflation is zero so real and nominal interest rates are equal: i=r.

• Goods market equilibrium is now:Y = C(Y-T) + I(Y,i) + G + NX(Y,Y*,E)

• Holding future expected exchange rate fixed, an appreciation today implies an expected depreciation over the next year

.• The $ must appreciate enough today so that expected rates of return on U.S. and European bonds are equalized, given the expected depreciation.

• Example: if i=i*=2% and i increases to 5% then exchange rate must appreciateby 3% today in order for it depreciateby 3% over the next year.

Fiscal and monetary policy:

• An expansionary fiscal policy (increase in govt spending) leads to an increase in output, a rise in the interest rate and an appreciation of the currency

.• A contractionary monetary policy leads to a rise in U.S. interest rates, a reduction in output and an appreciation of the currency.

Policymakers can use the IS-LM model developed in Chapter 21 "IS-LM"to help them decide between two major types of policy responses, fiscal (or government expenditure and tax) or monetary (interest rates and money). As you probably noticed when playing around with the IS and LM curves at the end of the previous chapter, their relative positions matter quite a bit for interest rates and aggregate output. Time to investigate this matter further.

The LM curve, the equilibrium points in the market for money, shifts for two reasons: changes in money demand and changes in the money supply. If the money supply increases (decreases), ceteris paribus, the interest rate is lower (higher) at each level of Y, or in other words, the LM curve shifts right (left). That is because at any given level of output Y, more money (less money) means a lower (higher) interest rate. (Remember, the price level doesn’t change in this model.) To see this, look at

he IS curve, by contrast, shifts whenever an autonomous (unrelated to Y or i) change occurs in C, I, G, T, or NX. Following the discussion of Keynesian cross diagrams in Chapter 21 "IS-LM", when C, I, G, or NX increases (decreases), the IS curve shifts right (left). When T increases (decreases), all else constant, the IS curve shifts left (right) because taxes effectively decrease consumption. Again, these are changes that are not related to output or interest rates, which merely indicate movements along the IS curve. The discovery of new caches of natural resources (which will increase I), changes in consumer preferences (at home or abroad, which will affect NX), and numerous other “shocks,” positive and negative, will change output at each interest rate, or in other words shift the entire IS curve.

We can now see how government policies can affect output. As noted above, in the short run, an increase in the money supply will shift the LM curve to the right, thereby lowering interest rates and increasing output. Decreasing the MS would have precisely the opposite effect. Fiscal stimulus, that is, decreasing taxes (T) or increasing government expenditures (G), will also increase output but, unlike monetary stimulus (increasing MS), will increase the interest rate. That is because it works by shifting the IS curve upward rather than shifting the LM curve. Of course, if T increases, the IS curve will shift left, decreasing interest rates but also aggregate output

If US prices increase faster than foreign prices:

Businesses, here and abroad, usually react to changes in the dollar's buying power. If the dollar depreciates in value, making U.S. goods cheaper overseas, American exports usually rise. The volume of imports may drop, as imported goods become more expensive. Some people will switch to American-made goods rather than pay the higher import price. The growth in American exports may increase overall American manufacturing and production to meet the market.

If the dollar becomes stronger, the process works in reverse. It's tougher to export if the value goes up. Imports become more desirable and can compete better with American-made goods

he rate of inflation in a country can have a major impact on the value of the country's currency and the rates of foreign exchange it has with the currencies of other nations. However, inflation is just one factor among many that combine to influence a country's exchange rate.

Inflation is more likely to have a significant negative effect, rather than a significant positive effect, on a currency's value and foreign exchange rate. A very low rate of inflation does not guarantee a favorable exchange rate for a country, but an extremely high inflation rate is very likely to impact the country's exchange rates with other nations negatively.

Inflation is closely related to interest rates, which can influence exchange rates. Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and often difficult to manage. Low interest rates spur consumer spending and economic growth, and generally positive influences on currency value. If consumer spending increases to the point where demand exceeds supply, inflation may ensue, which is not necessarily a bad outcome. But low interest rates do not commonly attract foreign investment. Higher interest rates tend to attract foreign investment, which is likely to increase the demand for a country's currency. (See also, The Mundell-Fleming Trilemma.)

The ultimate determination of the value and exchange rate of a nation's currency is the perceived desirability of holding that nation's currency. That perception is influenced by a host of economic factors, such as the stability of a nation's government and economy. Investors' first consideration in regard to currency, before whatever profits they may realize, is the safety of holding cash assets in the currency. If a country is perceived as politically or economically unstable or if there is any significant possibility of a sudden devaluation or other change in the value of the country's currency, investors tend to shy away from the currency and are reluctant to hold it for significant periods or in large amounts.

Other Factors Affecting Exchange Rate

Beyond the essential perceived safety of a nation's currency, numerous other factors besides inflation can impact the exchange rate for the currency. Such factors as a country's rate of economic growth, its balance of trade (which reflects the level of demand for the country's goods and services), interest rates and the country's debt level are all factors that influence the value of a given currency. Investors monitor a country's leading economic indicators to help determine exchange rates. Which one of many possible influences on exchange rates predominates is variable and subject to change. At one point in time, a country's interest rates may be the overriding factor in determining the demand for a currency. At another point in time, inflation or economic growth can be a primary factor.

Exchange rates are relative, especially in the modern world of fiat currencies where virtually no currencies have any intrinsic value, say, as defined in terms of gold, for which the currency could be exchanged. The only value any country's currency has is its perceived value relative to the currency of other countries or its domestic purchasing power. This situation can influence the effect that inputs—such as inflation—has on a country's exchange rate. For example, a country may have an inflation rate that is generally considered high by economists, but if it is still lower than that of another country, the relative value of its currency can be higher than that of the other country's currency.