PART 2. ANSWER ALL QUESTIONS. TOTAL 60 MARKS (10 marks ...
PART 2. ANSWER ALL QUESTIONS. TOTAL 60 MARKS (10 marks each).
Using figures for both the short run and the long run, show the effects of a permanent increase in the U.S. money supply. Try to line up your figures to the short and long run equilibria side by side. Assume that the U.S. real national income is constant.
Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.
Under fixed exchange rate, show using a figure, the effects of an expansionary fiscal policy in the short run only. Show the equilibrium under a flexible exchange rate. Explain the differences of the two exchange rate regimes.
1)
An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase is considered to continue in the future, and thus it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply (from point to point in the upper left figure). Now, in the long run, (the right hand side figure), prices will rise until the real money balances are the same as before the permanent increase in the money supply (from point 2 to point 4, in the lower right figure). Since the output level is given, the U.S. interest rate which decreased before, will start to increase, until it will move back to its original level 9from Point 2 to 4 in the lower left figure). The equilibrium interest rate must be the same as its original long run value (at point 4 in the lower right figure). This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply (this process is depicted in the upper right figure from point figure to pint
to ). So a large depreciation (from Point
in the left upper
in both the left and right upper figures) is followed by an appreciation of the dollar (the
movement from to point in the upper right hand side figure). Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real variables, such as output, investment, etc. Note that points same exchange rate.
and
represent the
2) The figure below shows the phenomenon of overshooting. A permanent increase in the money supply 1 2 starting from full employment equilibrium will shift the AA curve to the right from AA to AA . Now, a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run e equilibrium is reached. Note that point 3 is above point 1, because E is permanently higher after a e permanent increase in the money supply. The expected exchange rate, E , has risen by the same s percentage as M . Notice that along the adjustment path between the initial short-run equilibrium 2 (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E to 3 1 2 E ) following its initial sharp depreciation (from E to E ). This exchange rate behavior is an example of overshooting, in which the exchange rate's initial response to some change is greater than its longrun response.
3) An expansionary fiscal policy shifts the DD curve to the right. Under flexible exchange rate, point 2 in the figure is the equilibrium, e decreases (appreciates) and Y goes up. The picture is more complicated under fixed exchange rate, however, since E cannot change. Output is going up as a result of the fiscal expansion, and thus the demand for domestic money increases. To prevent the increased money demand from increase domestic interest rate above R, and with the appreciation of the currency, the central bank must buy foreign assets with domestic money and thereby increase the 0 money supply. The AA shifts to the right until E is restored to the initial fixed exchange rate, E , at point 3 in the figure. So under fixed exchanger rate, Y will increase by more than under flexible exchange rate regime. Unlike monetary policy, fiscal policy can be used to affect output under a fixed exchange rate. A central bank is forced to expand the money supply through foreign exchange purchases.
Using figures for both the short run and the long run, show the effects of a permanent increase in the U.S. money supply. Try to line up your figures to the short and long run equilibria side by side. Assume that the U.S. real national income is constant.
Using the DD-AA framework, show the phenomenon of overshooting. Use a figure to explain when it is taking place.
Under fixed exchange rate, show using a figure, the effects of an expansionary fiscal policy in the short run only. Show the equilibrium under a flexible exchange rate. Explain the differences of the two exchange rate regimes.
1)
An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase is considered to continue in the future, and thus it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply (from point to point in the upper left figure). Now, in the long run, (the right hand side figure), prices will rise until the real money balances are the same as before the permanent increase in the money supply (from point 2 to point 4, in the lower right figure). Since the output level is given, the U.S. interest rate which decreased before, will start to increase, until it will move back to its original level 9from Point 2 to 4 in the lower left figure). The equilibrium interest rate must be the same as its original long run value (at point 4 in the lower right figure). This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply (this process is depicted in the upper right figure from point figure to pint
to ). So a large depreciation (from Point
in the left upper
in both the left and right upper figures) is followed by an appreciation of the dollar (the
movement from to point in the upper right hand side figure). Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real variables, such as output, investment, etc. Note that points same exchange rate.
and
represent the
2) The figure below shows the phenomenon of overshooting. A permanent increase in the money supply 1 2 starting from full employment equilibrium will shift the AA curve to the right from AA to AA . Now, a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run e equilibrium is reached. Note that point 3 is above point 1, because E is permanently higher after a e permanent increase in the money supply. The expected exchange rate, E , has risen by the same s percentage as M . Notice that along the adjustment path between the initial short-run equilibrium 2 (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E to 3 1 2 E ) following its initial sharp depreciation (from E to E ). This exchange rate behavior is an example of overshooting, in which the exchange rate's initial response to some change is greater than its longrun response.
3) An expansionary fiscal policy shifts the DD curve to the right. Under flexible exchange rate, point 2 in the figure is the equilibrium, e decreases (appreciates) and Y goes up. The picture is more complicated under fixed exchange rate, however, since E cannot change. Output is going up as a result of the fiscal expansion, and thus the demand for domestic money increases. To prevent the increased money demand from increase domestic interest rate above R, and with the appreciation of the currency, the central bank must buy foreign assets with domestic money and thereby increase the 0 money supply. The AA shifts to the right until E is restored to the initial fixed exchange rate, E , at point 3 in the figure. So under fixed exchanger rate, Y will increase by more than under flexible exchange rate regime. Unlike monetary policy, fiscal policy can be used to affect output under a fixed exchange rate. A central bank is forced to expand the money supply through foreign exchange purchases.
