Question: 1. In the model of exchange rate and output determination, explain how

Question

Question:

1. In the model of exchange rate and output determination, explain how to derive the relationship between output and nominal exchange rates in both the output and the asset markets. Plot these relationships in one graph and explain the equilibrium condition.

(a) Using the relationships derived in problem 1, describe what happens to output and nominal exchange rates if the government decides to implement contractionary fiscal policy and people believe this policy is temporary. How would your answer differ if people believed this policy to be permanent?

(b) How would your answer to question (1) change if all important contracts were sticky and could not change in the very short run?

Explanation / Answer

Nominal exchange rate basically is a comparision of the domestic currrency with the foreign currency.

Any changes in the exchange rate in favour of the domestic currency ( in other words, domestic currency buying more units of foreign currency) would lead to decrease in output as in terms of foreign currency, the domestic output would be relatively expensive as a result of which demand would come down and output level would decrease.

Similary, in asset market too, domestic currency getting stronger would lead to contraction of asset market as foreign investors who usually make investment would be left with lesser money to purchase the stock and hence,

would lead to a reduuction in market.

a) A contractionary fiscal policy would lead to lesser supply of money into the market thereby increasing the value of the domestic currency in comarison with domestic currency.If people feel that this policy is temporary, then there won't be any significant change in demand as well as output as the market works on sentiment. Whereas, if it turns out to be permanent, exports will come down and the money being invested in asset market would also take a hit.

b) It means that contracts had already been prepared by the parties sensing the volatality of the exchange rate and hence, didn't let the fiscal policies or the monetary policy effect their strategy as they were already hedged against the flucutation. But in the long run,this strategy would not work and ultimately, there would be rethink over the exchange rate.and possible curtailment of the business by the people of different countries.

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