Chapter 10 Floating Exchange Rates and Internal Balance 253 estions 1. \"Oversho
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Chapter 10 Floating Exchange Rates and Internal Balance 253 estions 1. "Overshooting is the basis for the enhanced effectiveness of monetary policy under floating exchange rates." Do you agree or disagree? Why? blems 2 A Cotry e rates Do you agre or disagree? whe a floating exchange rate. Government spending now increases in an effort to reduce unemployment. What is the effect of this policy change on the exchange-rate value of the country's currency? Under what circumstances does the exchange-rate change reduce the expansionary effect of the fiscal change 3. "A drop in the foreign demand for our exports has a larger effect on our product and income under floating exchange rates than it would under fixed exch rates." Do you agree or disagree? Why? Describe the effects of a sudden decrease in the domestic demand for holding mone (a shift from wanting to hold domestic money to wanting to hold domestic bonds) on our domestic product and income under floating exchange rates. Is the change in do- mestic product and income greater or less than it would be under fixed exchange rates? (Hint: A decrease inthe demandfor money is like an increase int e suppl ofmoney ange 5. A country has a rising inflation rate and a tendency for its overall payments to go into deficit. Will the resulting exchange-rate change move the country closer to or further from internal balance? 6. Britain has instituted a contractionary monetary policy to fight inflation. The pound is floating. a. If the exchange-rate value of the pound remains steady, what are the elifects of tighter money on British domestic product and income? What is the effect on the British inflation rate? Explain b. Following the shift to tighter money, what is the pressure on the exchange-rate value of the pound? Explain. c. What are the implications of the change in the exchange-rate value of the pound for domestic product and inflation in Britain? Does the exchange-rate change tend to re- inforce or counteract the contractionary thrust of British monetary policy? Explain. 7. In the late 1980s, the United States had a large government budget deficit and a large current account deficit. The dollar was floating. One approach suggested to reduce e yalue of the dollar remained steady, how would this change t the U.S. current both of these deficits was a large increase in taxes.Explanation / Answer
2. The direction of the response of the exchange rate is consistent with basic macroeconomic theory; in an economy with a flexible exchange rate, government spending shocks should lead to appreciation of the domestic currency. The dynamics of the appreciation are broadly in line with economic theory as well. While the exchange rate peaks with a delay, the duration of the delay is fairly short relative to previous studies where the maximum reaction was delayed by many months. Interestingly, when we aggregate data to the monthly frequency, the delay becomes more pronounced – the response peaks after six months.
Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth in the short-term. Higher government spending will also have an impact on the supply-side of the economy – depending on which area of government spending is increased.
Higher government spending could be on
It depends on how the government spending is financed. If government spending is financed by higher taxes, then tax rises may counter-balance the higher spending, and there will be no increase in aggregate demand (AD).
If the economy is close to full capacity, higher government spending can lead to crowding out. This is when the government spends more, but it has the effect of reducing private sector spending. For example, if government borrows from the private sector, the private sector has lower savings for private investment.
The impact of government spending also depends on the state of the economy. If the economy is close to full capacity, then higher government spending may cause inflationary pressures and little increase in real GDP. If the economy is in recession, and the government borrows from the private sector, it can act as expansionary fiscal policy to boost economic growth
The increased government spending may create a multiplier effect. If government spending causes the unemployed to gain jobs, then they will have more income to spend leading to a further increase in aggregate demand. (e.g. construction workers employed by government increase spending in pubs and transport, causing other sectors of the economy to benefit from the government spending). In these situations of spare capacity in the economy, the government spending may cause a bigger final increase in GDP than the initial injection. This will lead to stronger currency and higher exchange rate.
Fiscal policy, which is the use of government spending or taxes to grow or slow down the economy, can affect the exchange rate in three different ways. It can affect exchange rates through income changes, price changes, and interest rates.
Income Changes: When the government lowers your taxes through fiscal policy, it puts more income in your pocket! This means more shopping and morning stops at the local coffee shop, usually resulting in overall increased demand for goods and services. This means more imports. You have more money; you want to spend it! The rise in imports results in U.S. citizens selling more dollars to buy foreign currencies to pay for those imported goods. This decreases the dollar exchange rate, ultimately leading to more expensive products in the future.
Price Changes: When the government wants to grow the economy, it is known as expansionary policy. To do this, the government can reduce taxes or spend more to stimulate the economy. When the government spends more or decides to cut your tax bill, this ultimately leads to increased demand, which pushes the overall price of goods and services higher.
As the prices of goods increases, this also makes exports of our goods to other countries more expensive and imports more attractive. This leads to higher demand for foreign currency to buy goods and lower demand for dollars to purchase U.S. goods. This lowers the exchange rate. Contractionary policy, which is characterized by a decrease in government spending or increases in taxes, has the opposite effect.
Interest Rates Now that we have seen how income and price levels can affect the exchange rates, let's see how interest rates work. When the government takes an expansionary fiscal approach and wants to increase its spending, it has to get that money from somewhere. To do that, it sells bonds, which raises the interest rates. This higher U.S. interest rate causes foreign dollars to flow into the United States because foreign investors are attracted to the higher interest rates, which give them a better return on their money. People are always looking for a good return on their money!
This increased flow of capital pushes up the U.S. exchange rate. On the contrary, contractionary fiscal policy leads to lower interest rates and more capital flowing out of the U.S. and pushes down the exchange rate.
4.
With floating exchange rates monetary policy exerts strong influence on domestic product and income. A change in monetary policy results in a change in the country's interest rates. Both the current account and the capital account tend to change in the same direction. To keep the overall payments in balance, the exchange rate must change. The exchange rate change results in a change in international price competitiveness, assuming that it is larger or faster than any change in the country's price level-overshooting. The change in price competitiveness results in a change in net exports that reinforces the thrust of the change in monetary policy. We can picture the change in monetary policy as a shift in the LM curve, and then a shift in the IS and FE curves to a new triple intersection as the exchange rate and price competitiveness change.
With floating exchange rates the effect of a change in fiscal policy depends on how responsive international capital flows are to changes in interest rates. If capital flows are sufficiently responsive, then the exchange rate changes in the direction that counters the thrust of the fiscal policy change-an effect sometimes called international crowding out. If capital flows are not that responsive (or as we enter into the longer time period when the capital flows have slowed), the change in the current account dominates, so that the exchange rate changes in the direction that reinforces the thrust of the fiscal policy change. Both cases are shown as a shift in the IS curve, with the position of the intersection between the new IS curve and the LM curve being above or below the initial FE curve, depending on how flat or steep the FE curve is. The exchange rate change then shifts both the IS and FE curves toward a new triple intersection.
Domestic monetary shocks have strong effects on domestic product, with the exchange rate change reinforcing the thrust of the shock. The effects of domestic spending shocks depend on how responsive international capital flows are to changes in interest rates. International capital flow shocks affect the domestic economy by changing the exchange rate and the country's international price competitiveness. International trade shocks result in changes in the exchange rate that mute the effects of the shocks on domestic product.
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