Question

During the slow recovery from the global nancial crisis, central banks in many advanced countries kept their interest rates at historically low levels, which we can interpret as lowering the global interest rate, r. Imagine you are the economic adviser for a small island nation open to international trade.

a) How would the fall in the global real interest rate aect the level of Output based on the real money market (LM Curve)? What happens to the LM curve after this change? Brie y explain your answer.

b) Before the move to short run equilibrium, the domestic real interest rate is temporarily higher than the interest rate in the rest of the world. How does this aect where investment funds will want to ow (into the country or out of the country)? How does that ow of loanable funds aects the supply or demand for your country's currency in the market for foreign exchange?

c) Suppose your island nation currently uses a oating exchange rate regime. What must happen to the nominal exchange rate to reach short run equilibrium after r falls? Explain how this change in the nominal exchange rate occurs based on the supply and demand for your country's currency.

d) How is short run equilibrium reached in the Mundell-Fleming model based on the change in the exchange rate? Make sure to explain your answer using the underlying models of the IS and LM curves.

e) Suppose government ocials came to you and proposed having a xed exchange rate rather than a oating exchange rate. What would the country's central bank have to do in order to maintain the old exchange rate? What eect would this have on short run equilibrium output compared to a exible exchange rate?

f) Would you advise your country to maintain its oating exchange rate regime or switch to a xed exchange rate at the exchange rate before the fall in r? Explain your decision.

Answer 1

a) As the world interest rate falls, the domestic interest rate will also have to be reduced. Thus, the Speculative demand for money will increase, to provide for which money supply in the economy will have to increase and the LM Curve will shift to the right.

b) When the domestic interest rate is higher than the interest rate in the rest of the world there will be net capital inflow that is foreign investments will flood the domestic economy. There will be excess supply of the foreign currency in the foreign exchange market which means that the price of foreign currency will fall. The domestic real exchange rate will appreciate.

c) As there us excess supply of foreign currency, its price will fall. Consequently, the value of the domestic currency will increase due to excess demand for domestic currency and the nominal exchange rate will fall. This means the domestic currency will gain value in terms of the foreign currency. This is denoted as appreciation of the nominal exchange rate.

d) In the Mundell Fleming Model with perfect capital mobility, when the exchange rate appreciates, net exports fall and the IS curve shifts to the left. There is a fall in the interest rate and a balance of payments deficit. To maintain BOP equlibrium the exchange rate now begins to depreciate that is domestic currency loses value in terms of foreign currency. Exports become cheaper, net exports increase and the IS curve gradually shifts right till it returns to its initial equlibrium position.

e) In order to maintain a fixed exchange rate, the central bank officials will have to sterilise the foreign exchange market by tapping into their foreign exchange reserves. When there is an excess demand for foreign currency, they will supply it to prevent an increase in its price and vice versa.

In this situation, to prevent the depreciation of the currency the Central Bank will supply foreign currency, the stock of high powered money in the economy will fall, the money supply will fall and the output will decrease.

f) I will advise my country to maintain the flexible exchange rate as it allows my country to isolate itself from foreign disturbances and also does not decrease my country's output unlike in the fixed exchange rate system.