Deck 13: International Linkages

Question 1

Assume that capital is perfectly mobile, the price level is fixed, and the exchange rate is flexible. Now let the government increase purchases. Explain first why the equilibrium levels of output and the interest rate are unaffected. Then show whether the current account improves or worsens as a result of the increased government purchases of goods and services.

Answer 1

The rate at which one countries currency exchanged with other countries currency is known as exchange rate. It also defines as the value of one currency in relation to another currency.
As given in the question that the capital is perfectly mobile, the price level is fixed, and the exchange rate is flexible. In this case an increase in government expenditure will not affect output and interest rate as showing in the below diagram- 1 that IS shift to IS 1 because of increase in government expenditure it increases interest rate capital inflow in the country, B.O.P surplus creates pressure to currency appreciate. Due to currency appreciates imports increases and net export fall. It results in IS 1 shift back to IS, so no change in output and interest rate.
Current account worsens as a result of increased government expenditure because as discussed above it results in appreciation of currency and so imports increases, net export fall so current account deficit.
Conclusion: Increase in government expenditure in flexible exchange rate regime is ineffective to change in output.

Question 2

Consider a country that is in a position of full employment and balanced trade. The exchange rate is fixed, and capital is not mobile. Which of the following types of disturbance can be remedied with standard aggregate demand tools of stabilization Indicate in each case the impact on external and internal balance as well as the appropriate policy response.
a. A loss of export markets.
b. A reduction in saving and a corresponding increase in demand for domestic goods.
c. An increase in government spending.
d. A shift in demand from imports to domestic goods.
e. A reduction in imports with a corresponding increase in saving.

Answer 2

The given economy is currently in the full employment position and it runs a balanced trade. The foreign exchange rate for this economy is fixed and there is imperfect capital mobility. The current situation therefore ensures both external and internal balances. Given that exchange rate is fixed, there is no monetary autonomy which implies the central bank has to intervene to restore the committed value of the exchange rate, if it changes.
a)
If loss of export markets occurs. This indicates that net exports will fall. There will be trade imbalance or a deficit. There is an internal and external imbalance as demand for domestic currency is also reduced. IS would shift to the left. Domestic rate of interest will reduce and this creates unemployment.
b)
When there is a reduction in saving, domestic savings will fall. Fall in savings would imply a relative increase in global investment in home country so that there is a capital inflow. When this happens, there is an increased demand for home currency and currency appreciates.
Central bank intervenes and buys foreign currency to release domestic one. This depreciates the currency. At the same time there is a corresponding increase in demand for domestic goods which increases the price level. In the end there is a depreciation of currency and central bank again intervenes to restore the exchange rate.
c)
An increase in government spending would shift the aggregate demand curve to the right. This would increase the rate of interest, bring foreign capital and appreciate the currency. Central bank immediately intervenes, increases money supply and releases domestic currency. This reduces the rate of interest and overstimulate the economy.
d)
A shift in demand from imports to domestic goods would increase the price level and the level of real GDP as net exports rise. This raises the level of inflation and the currency depreciates. Trade surplus occurs and central bank intervenes to reduce the money supply. This will increase the rate of interest and bring the economy back to its original equilibrium.
e)
A reduction in imports will lead to a higher net exports and currency depreciation. Along with this, there is a corresponding increase in saving which leads to saving outgrowth. This will cause currency depreciation and so the central bank will conduct open market operations to release forex reserves. This will appreciate the currency, and bring back the savings. Imports will relatively increase and economy reaches back to its old equilibrium.

Question 3

In 1990-1992 Finland fell into serious difficulties. The collapse of exports to the Soviet Union and a dramatic fall in the prices of pulp and paper-important export items-led to both a recession and a current account deficit. What adjustment policies would you recommend for such a case

Answer 3

When the nation experienced a loss in its export market, there was an increase in the domestic supply of these goods which were used to be exported. This caused the price of the exported goods to fall. Exported items that experienced a fall also contained pulp and paper. This reduction in the exports led to a fall in net exports which implied a current account deficit.
Since net exports are a part of aggregate demand as well, such a fall will reduce the aggregate demand, reducing the overall price level and the level of real GDP.
There was a recession and the economy needed a stimulus. A fiscal expansion would have increased the aggregate demand through the interest rate channel. It will increase the domestic income and so consumers import more. Higher rate of interest will bring in more capital from foreign investors which will improve the capital account.
However, a reduction in the level of net exports due to higher relative imports will cause further deficit in the trade balance.
A monetary expansion on the other side, will reduce the rate of interest and so it will improve the trade deficit. This is done when it is able to reduce the value of domestic currency and causes exports to rise. Real GDP and employment both will rise and this will worsen capital account as capital outflows occur.
Hence, a monetary expansion is favourable because it improves current account.

Question 4

Explain how and why monetary policy retains its effectiveness when there is perfect mobility of capital.

Question 5

Suppose you expect the pound to depreciate by 6 percent over the next year. Assume that the U.S. interest rate is 4 percent. What interest rate would be needed on pound securities, such as government bonds, for you to be willing to buy those securities with your dollars today and then sell them in a year in exchange for dollars

Question 6

If the dollar-pound exchange rate rises, has the dollar depreciated or appreciated
b. What has happened to the pound

Question 7

Illustrate, graphically, the effects of a fiscal expansion when capital is mobile and both prices and exchange rates are fixed. Over what horizon is the assumption of fixed prices a valid one Explain.

Question 8

What is the difference between depreciation and devaluation

Question 9

What is the effect of a fiscal expansion on output and interest rates when exchange rates are fixed and capital is perfectly mobile Show this rigorously, using the model developed in Section 13-5.

Question 10

Explain the purchasing power parity theory of the long-run behavior of the exchange rate. Indicate whether there are any circumstances under which you would not expect the PPP relationship to hold.

Question 11

This question is concerned with the repercussion effects of a domestic expansion once we recognize that, as a consequence, output abroad will expand. Suppose that at home there is an increase in autonomous spending, D A , that falls entirely on domestic goods. (Assume constant interest rates throughout this problem.)
a. What is the effect on income, disregarding repercussion effects What is the impact on our imports Denote the increase in imports by

b. Using the result for the increase in imports, consider what happens abroad. Our increase in imports means that foreign countries experience an increase in their exports and therefore an increase in the demand for their goods. In response, their output expands. Assuming the foreign marginal propensity to save is s * and the foreign propensity to import is m *, by how much will a foreign country's income expand as a result of an increase in its exports
c. Now combine the pieces by writing the familiar equation for equilibrium in the domestic goods market: Change in supply,
equals the total change in demand,



Noting that our increase in exports,
is equal to foreigners' increase in imports, we can replace
with the answer to part b to obtain a general expression for the multiplier with repercussions.
d. Substitute your answer to part b in the formula for the change in our exports,

e. Calculate the complete change in our income, including repercussion effects. Now compare your result with the case in which repercussion effects are omitted. What difference do repercussion effects make Is our income expansion larger or smaller with repercussion effects
f. Consider the trade balance effect of a domestic expansion with and without repercussion effects. Is the trade deficit larger or smaller once repercussion effects are taken into account

Question 12

Why do economists care whether or not PPP holds

Question 13

When is a country in external balance Internal balance Should either or both of these be policy goals

Question 14

According to the Mundell-Fleming model, when exchange rates are fixed and capital is perfectly mobile, will fiscal or monetary policy be more successful Explain.

Question 15

It is sometimes said that a central bank is a necessary element for a balance-of-payments deficit. What is the explanation for this argument

Question 16

Your country is in recession. You feel that a policy of exchange rate depreciation will stimulate aggregate demand and bring the country out of the recession.
a. What can be done to trigger this depreciation
b. How might other countries react
c. When would this be a beggar-thy-neighbor policy

Question 17

Go to http://research.stlouisfed.org/fred2. Click on "Categories," under "Money, Banking, Finance" select "Exchange Rates" and then "By Country." Find two countries that had a fixed exchange rate for a period sometime during the last 20 years. [ Hint: Choose one of the developing countries (e.g., Malaysia, Thailand). ]