Fixed and Flexible Exchange Rates
1. In the past few years, a number of policy makers (especially in Asian countries) have expressed their dissatisfaction with flexible exchange rates and have advocated a return to fixed rates. You have been asked to advise the CEO of your company on the relative abilities of fixed and flexible rates to stabilize economy (keep equilibrium GDP at a constant level) in the face of temporary shocks.
a) Assume that Hong Kong is a small open economy initially at full employment GDP. Show this on the IS-LM diagram.
b) Suppose first that exchange rates are fully flexible. Now, suppose that there is a decrease in demand from abroad (say, a decrease in tourism) that lowers net exports. Show the effect of this 'demand shock' on the level of GDP and the exchange rate and the interest rate.
c) Next return to the initial equilibrium in part (a). Suppose now that the economy has adopted fixed exchange rates. Now, suppose that there is the same 'demand shock' as above-that is, there is a decrease in net demand from abroad (say, a fall in tourism) that lowers net exports. Show the effect of this 'demand shock' on the level of GDP and interest rate
d) Return to the initial equilibrium (1 part a) and assume once again that exchange rates are flexible. Suppose that instead of a foreign demand shock, the initial equilibrium is disturbed by a decrease in domestic money demand (say, because of the invention of the credit card). Show the effect of this decrease in money demand. What is the effect of this 'monetary shock' on the level of GDP and on the exchange rate?
e) Finally, return to the initial equilibrium in 1 part (a). Suppose now that the economy has adopted fixed exchange rates (and that the exchange rate was fixed at the initial equilibrium value). Now, suppose that there is the same 'monetary shock' as above – that is, domestic money demand falls. Analyze the effect of the domestic money demand shock on GDP and the exchange rate.
f) What conclusions can you draw for your CEO on the ability of fixed and flexible exchange rates to stabilize the economy in the face of demand and monetary shocks?
2. The following questions are based on the attached article ("A Working Model").
In the past few years, there have been lower interest rates and higher output globally. The article explores possible reasons for this phenomenon.
a) Suppose there has been an increase in global savings (or more precisely 'savings increases relative to investment').
Show the effect on the IS-LM diagram (which curve would be affected and why).
What happens to interest rates (yields) and output?
b) Suppose instead that there was loose global monetary policy (in this part, assume that there has been no change in savings).
Explain how central banks would conduct 'loose' monetary policy? What happens to the demand for bonds, the price of bonds and the yields?
Show what happens on the IS-LM diagram. What happens to interest rates and output?
c) Now suppose that there is both an increase in global savings and loose global monetary policy. Show the combined effects on the IS-LM diagram.
3. The following questions are based on the attached article ("Europe's Monetary Union"). There are three underlined sections labeled A, Band C.
i. Explain using the IS-LM diagram the consequences of a fall in the demand for domestic products on domestic income.
ii. Explain and show graphically what the central bank could do to offset this consequence
b) Explain using the IS-LM diagram, what an independent New England could have done in the foreign exchange market to offset this contraction in demand for domestic goods.
c) Now, since New England is not 'independent', it foregoes the above policy option. Explain and show graphically the economic consequences for New England of the federal government's 'automatic stabilizer'. Explain what 'automatically' happens to demand for domestic (i.e. New England) products.