International Finance - Section 4 with answers

Richard Walker, Northwestern University

These questions use the LRGME/LRMME/SRGE/SRMME frame work from class.

1. Show on a diagram the short and long-run effects of an unexpected fall in government spending G. You can
assume that the forex markets expectations of the future exchange rate immediately adjusts to equal the new
long-run level.

P LRGM E1

SRGM E1

1
P1 = P e LRM M E1

SRM M E1

E
E1 = E e

We start at point 1 above with LRM M E1 , SRM M E1 , LRGM E1 and SRGM E1 . Sudden fall in G
causes LRGM E to swivel right, as we need a rise in N X and thus a long-run real depreciation;
no change in LRM M E. New long-run equilibrium is thus at point 2 below.

P LRGM E1

LRGM E2
SRGM E2

1 2
P1 = P e LRM M E1

SRM M E2

E
E1 E2 = E e

1
Since the forex market instantly switches its expectations so that E e = E2 , and with P e fixed at
P1 via the already-written nominal wage contracts, we can use the two rules of thumb1 to draw
SRM M E2 and SRGM E2 as above. So, point 2 is the short-run equilibrium as well as the
long-run equilibrium, and there are in fact no interesting short-run dynamics. As soon as G
falls the nominal exchange rate jumps up to its new long-run level, providing the real
depreciation needed to raise N X and avoid any short-term recession. Output remains at Y .

This is an example of a general phenomenon: flexible exchange rates acting as a cushion in the
face of demand shocks (here a negative fiscal shock). Well see later this quarter how things
differ when a central bank tries to keep the exchange rate fixed.

2. Again show on a diagram the short and long-run effects of an unexpected fall in government spending G,
but this time assume it is accompanied by a simultaneous (and similarly unexpected) increase in the nominal
money supply M s . Once again assume that the forex markets expectations of the future exchange rate
immediately adjusts to equal the new long-run level.

P LRGM E1

LRGM E2

2 SRGM E2
P2 LRM M E2
A

SRM M E2

1
P1 = P e LRM M E1

E
E1 E2 = E e

Again the forex market instantly switches its expectations so that E e = E2 (note that this E2 is
greater than the one in question 1), and with P e fixed at P1 via the already-written nominal
wage contracts, we can again use the two rules of thumb to draw SRM M E2 and SRGM E2 as
above. So, point A is now the short-run equilibrium, so this time we have some interesting
short-run dynamics. As soon as G falls and M s rises the nominal exchange rate jumps up above
its new long-run level. Then, over time, nominal wage contracts are rewritten to reflect higher
price expectations P e ; via the rule of thumb this means that the SRGM E lines intersection
with the LRGM E will also rise, and (since we must always be in a short-run equilibrium where
the SRGM E and SRM M E intersect) we travel north-west up the SRM M E2 line towards point 2,
our long-run equilibrium. Eventually all the nominal wage contracts are rewritten so that
P e = P2 , and then all four lines intersect at point 2.

Dynamics: E overshoots and then comes down to its new (higher) long-run level; N X and real
exchange rate have similar paths to E; P jumps up but under-adjusts in the short-run; output

1 SRM M E cuts LRM M E at E e , SRGM E cuts LRGM E at P e .

2
jumps up and then comes back down to Y ; domestic interest rate jumps down below Rf and
then comes back up to equal Rf in equilibrium.