Consider the extended (open economy) real inter-temporal model with investment.

Question

Consider the extended (open economy) real inter-temporal model with investment. Suppose the government implements a temporary fiscal stimulus (i.e. temporary increase in government spending). (a) Suppose the small open economy is under a flexible exchange rate regime. (i) Assuming no capital control, show the impact of this policy on output, employment, real wage, real interest rate, current account, capital account, and nominal exchange rate. (ii) Now suppose the government prohibits all capital inflows and outflows. How does your answer to the previous part change with this form of capital controls? (b) Suppose the small open economy is under a fixed exchange rate regime. (i) Assuming no capital control, show the impact of this policy on output, employment, real wage, real interest rate, current account, capital account, and nominal exchange rate. (ii) Now suppose the government prohibits all capital inflows and outflows. How does your answer to the previous part change with this form of capital controls?

Explanation / Answer

1. The open economy under flexible exchange rate- The rate which is determined according to market forces viz. demand and supply of foreign exchange. These are of two types - Free floating and Managed floating

Sources of demand for foreign exchange-

1. For imports of goods and services

2. Withdrawl of deposits by the foreigners.

3. Repayment of loans

4. To make investment.

Sources of supply of foreign exchange-

1. Exports of goods and services

2. Remittance by residents working abroad

3. Loans and borrowing

4. Inflow of investment.

Fixed Exchange Rate Regime-

In fixed exchange rate regime the rate of exchange between currencies of different countries are fixed by the govt. of a country.

Merits- 1. It reduces the risk of investment and international trade.

2. It restricts the speculation activities

3. It is helpful in automatic correction of monetary errors.

4. It works as a check on macroeconomics policies

Disadvantages- 1. It has contradiction with the objectives of free market

2. Fixed exchange regimes are unable to adjust the shocks.

3 Balance of payments deficits may lead to recession

4. It makes monetory policy ineffective

5. Competitive deflations may lead to world depression.

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