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Tutorial 9 (Chapters 20 and 21) Output, the

interest rate and the exchange rate, Exchange


rate regimes
HAND IN DATE: MONDAY 23rd OF OCTOBER 2017
Instructions: You are required to hand in Q1, Q3, Q4 and the 12 MCQs.
The remaining question is good for practice. So, do attempt to answer it.
Question 1 [25 marks]

a) Assume an open economy is operating in the short run and under flexible exchange
rates. Explain why the IS curve is downward sloping. (10 marks)
Answer:
A reduction in interest rate (i) with zero inflation will cause investment to increase.
This causes an increase in ZZ and Y. There is a second effect now embedded in the IS
curve. As i falls, the demand for the domestic currency drops causing a depreciation.
This depreciation causes NX to rise and demand to rise even more. So, there are two
components of demand that now change as i changes: I and NX. Hence the IS is
downward sloping because i and Y move in opposite directions.

b) Explain what the IP curve is and why it is upward sloping. (6 marks)


Answer:
The IP curve represents the combinations of i and E that maintain the interest rate
parity condition. As i (domestic interest) falls, foreign bonds will have a higher expected
return. The demand for the domestic currency will fall causing a depreciation of E. So the
drop in i causes E to fall. On the other hand, if i increases then E will also increase. Thus
there is a direct relationship between i and E which causes the IP to be upward sloping.

c) For a country pursuing a fixed exchange rate regime, what does the interest rate parity
condition imply about domestic and foreign interest rates? Explain. (5 marks)
Answer:
As long as the fixed exchange rate regime is credible, the interest rates must be equal.
If the exchange rate regime is credible, we know that there will be no expected appreciation
or depreciation so i = i* because E = Ee.

d) To what extent can monetary policy be used to affect output in a fixed exchange rate
regime? Explain. (4 marks)
Answer:
It cannot. To peg the exchange rate, the central bank must keep the domestic interest rate
equal to the exogenous foreign interest rate as long as there is perfect capital mobility. The
domestic central bank cannot independently change its interest rate.
Question 2 [25 marks]
Using an IS-LM-IP model, contrast the short run effects of an expansionary fiscal policy in
an open economy with (i) a fixed exchange regime, and (ii) a flexible exchange rate regime.
Make sure you clearly explain the dynamics behind all shifts in curves and equilibria and do
not forget to discuss the changes in the components of demand. You may use one diagram or
two, but make sure that the model and all curves and equilibria are clearly labelled. Be sure
to point out the differences between the policy implications under the two regimes.
Answer:
Flexible Exchange Rate Regime

Assume the economy is initially in short run equilibrium at A on the graph below; with
output (Y) at Y1, the interest rate (i) at i1 and the nominal exchange rate (E) at E1. An
increase in government spending (G) will cause the IS curve to shift to the right from IS1 to
IS2. This will lead to a rise in Y from Y1 to Y2, an increase in i from i1 to i2 and a nominal
appreciation of the exchange rate from E1 to E2.

IS-LM-IP Model

i i
IP
LM1

LM2
B

i2
C
i1
A
IS2
IS1

Y1 Y2 Y3 Y E1 E2 E
The increase in G constitutes an increase in aggregate demand (Z). Z now exceeds Y and this
results in producer stockpiles starting to decline. Producers react to falling stockpiles by
increasing their production and thus Y rises.

The result of higher Y and Z is a larger number of transactions. Thus people demand more
money. People now want to sell bonds as they require more money for transactions. This
decrease in demand for bonds drives bond prices down and thus i rises.

With a higher i, domestic bonds become more attractive relative to foreign bonds. Capital
inflows follow as people shift their financial investments to more attractive domestic bonds.
People now buy domestic currency in exchange for foreign currency to buy domestic bonds
and the demand for domestic currency rises. Thus the price of the domestic currency in terms
of foreign currency increases and we have a nominal appreciation of the domestic currency.
Since the appreciation of the Rand has made foreign goods cheaper relative to domestic
goods, the trade balance deteriorates. Domestic consumers demand more foreign imports
(since they are now cheaper) and foreign consumers demand fewer domestic exports (since
they are now more expensive). Also there is a higher demand for imports due to the higher
level of domestic income. Thus net exports decrease in the short run.
Effects on demand under flexible exchange rate regime

After the increase in G, the economy is at B (Y2 and i2 and E2). Consumption spending (C)
has risen as disposable income has increased with Y. The change in investment is
indeterminate as i has risen (increasing the cost of investment) and Y has risen which
increases the incentive to invest. Net export have decreased (assuming the Marshall-Lerner
condition holds) due to the appreciation of the domestic currency and the increase in Y.
Fixed Exchange Rate Regime
Everything above that has been discussed (except the last paragraph about the components of
demand) is also true for the first shift under the increase in G under fixed exchange rates.
Under fixed exchange rates, the domestic central bank is forced to pursue an expansionary
monetary policy to prevent the appreciation of the currency. Thus the LM curve shifts to the
right, Y increases further, i falls back to its previous level and E returns to its previous value.
The new equilibrium under fixed exchange rates is at C.
An increase in the supply of money results in people having excess liquidity. In response the
demand for bonds increases as people wish to hold less money. Thus bond prices are bid up
and i falls back to i1 until people are happy to hold the amount of money that they have.
With a lower i, domestic bonds become less attractive relative to foreign bonds. Capital
flight follows as people shift their financial investments to more attractive foreign bonds.
People now sell domestic currency in exchange for foreign currency to buy foreign bonds and
the demand for domestic currency falls. Thus the price of the domestic currency in terms of
foreign currency decreases and we have a nominal depreciation of the domestic currency,
back to the initial value (E1).
Lower i lead to higher I, as the cost of I is now lower for firms. Simultaneously net exports
rise. Thus Z increases above Y, causing producer stockpiles to fall. Producers respond by
further increasing production from Y2 up to Y3.
Since the depreciation of the Rand has made foreign goods more expensive relative to
domestic goods, the trade balance improves. Domestic consumers demand fewer foreign
imports (since they are now more expensive) and foreign consumers demand more domestic
exports (since they are now cheaper). There is a dampener on this because Y has increased,
increasing the demand for imports. But overall net exports decrease in the short run.
Effects on components of Demand under Fixed Exchange Rate Regime
Thus under a fixed exchange rate regime, the increase in G with the required accommodation
of monetary policy leads to an increase in output greater than that in the flexible exchange
rate regime, but no change in i or (obviously) E. C thus increases (more than the increase
under flexible exchange rates) since Y has risen and I increases (as opposed to the
indeterminate change under flexible exchange rates) since Y increases, increasing incentives
to invest. Net exports have decreased slightly due to the increase in income.
Question 3 [30 marks]
Country A and Country B are two open economies with flexible exchange rates.
a) Using an IS-LM-IP model, discuss the short-run effects of country A’s
implementation of an expansionary monetary policy. Make sure you clearly explain
the dynamics behind the shifts of the curves and the change in the equilibrium values
of output and the interest rate. Furthermore, remember to discuss the changes in the
components of aggregate demand. [20 marks]

Answer:
a) Assume the economy is initially in short run equilibrium at point A on graph (a)
with output Y1 and interest rate i1 and the nominal exchange rate at E1. At a given
level of output, an expansionary monetary policy leads to a decrease in interest
rate. This causes the LM curve to shift from LM 0 to LM1. Because money does not
directly enter the IS relation, the IS curve does not shift. The equilibrium moves
from point A to point B where output increases from Y 1 to Y2. At the same time,
the interest rate will decline from i1 to i2. This change in interest rate results in
the exchange rate depreciating from E1 to E2.
An increase in money supply results in people having excess liquidity. In response
the demand for bonds increases as people wish to hold less money. Thus bond
prices are bid up and interest rate falls. With lower i, domestic bonds become
less attractive relative to foreign bonds. Capital flight follow as people shift their
financial investments to more attractive foreign bonds. People now sell domestic
currency in exchange for foreign currency to buy foreign bonds and the demand
for domestic currency falls. Thus the price of the domestic currency in terms of
foreign currency decreases and we have a nominal depreciation of the domestic
currency at E2.
Lower i and E both increase demand for domestic goods which signals domestic
producers to produce more given the current level of output. The increase in
production causes income to increase which further causes the demand to
increase via C and I. The increase in demand eventually leads to further rise in
output until the new equilibrium is reached through the multiplier effect at
output Y2.
As output increases, money demand rises due to more transactions, leading to a
higher interest rate and offsetting some of the initial decrease in the interest rate
in the equilibrium financial markets and some of the initial depreciation.
Aggregate demand: Y=C + I + G + X – M.
Output (Y) increases. Consumption increases due to an increase in income(Y) and
a decrease in i. Investment increases because of low interest rate (i) and an
increase in income (Y). G stays the same.
Initially exports and import quantities do not change but import bill increases
causing the value of imports in terms of domestic goods to increase. This causes
NX to decrease given its short run period. Alternatively, due to the depreciation
of the domestic currency, foreign goods are more expensive (trade balance
improves). Domestic consumers demand fewer foreign imports (since they are
expensive). Foreign consumers demand more domestic exports (since they are
now cheaper). But overall net exports decrease slightly in the short run due to
the increase in Y which results in an increase in imports.

b) Country B is identical to the economy in section (a) above with the exception that
its aggregate investment is more responsive to changes in the interest rate and it
applies a higher tax rate on imports. Based on the characteristics of country B’s
economy, discuss the effectiveness of implementing an expansionary monetary
policy similar to the economy in section (a) on the equilibrium level of output in
the two countries. [10 marks]

Answer:
The expansionary monetary policy has the same effects of shifting the LM curve
down and resulting in the depreciation of the exchange rate as explained in (a)
above. The dynamics are also the same. However, the effects on aggregate
demand for country B will be different due to its aggregate investment being
more responsive to changes in interest rate and its policy of higher tax rate on
imports.
Aggregate demand: Y= C + I + G + X-M
Output in country B will be higher than in the country discussed in section (a)
because the lower i in country B will make their firms to be more sensitive and
adjust their production in larger magnitude and thus more output will be
produced. Consumption in country B will also increase due to an increase in
income (Y) and lower interest rate but will be more compared to country A. The
increase in income will also be spent a lot in the domestic country which also
helps in increasing more output. Investment will also increase in country B
because of lower interest rate and higher income (Y) but it will be higher than
the country in section (a) due to sensitivity to interest rates. G stays the same.
Overall net exports in country B will improve compared to the country in section
(a) because the increase in income will result in less being spent on imports due
to the tax imposed compared to the country in section (a).
Thus for country B, output increases from A to C i.e. Y1 to YB, interest rate
decreases from i1 to iB and exchange rate depreciates from E1 to EB. This implies
that an expansionary monetary policy is more effective in country B than country
A.

Question 4 [30 marks]


a) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain the effects of an increase in money supply on the
domestic economy. Clearly label all your curves and equilibrium points. Also explain
what happens to the components of demand. (20 marks)
Answer
The solution is similar to question 3a above.
b) Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate and
explain the effects of an increase in consumer confidence on the domestic economy. Clearly
label all your curves and equilibrium points. (15 marks)
Answer:
An increase in consumer confidence causes consumption (C) to increase. This causes demand
to increase and the IS curve to shift to the right. As Y rises, money demand will increase and
the domestic interest rate will tend to rise. On the graph, this causes interest rate to increase
from i0 to i1 and output to increase from Y0 to Y1. Moving from point A to B on IS curve
IS1. If i rises, there will be an appreciation of the domestic currency as demand rises. The
central bank cannot let this happen. To prevent this, the central bank must increase the money
supply so that i does not rise. This increase in money supply then shifts the LM curve to LM1
where i=i*. Hence equilibrium increases from point A to point C where IS1 intersects LM1.
Output increases from Y0 to Y2, no change in domestic interest rate, an increase in
investment due to an increase in Y and there is a reduction in NX caused by the rise in
imports.
MULTIPLE CHOICE QUESTIONS [24 marks – 2 marks for each MCQ]
1. Assume that the price levels in two countries are constant. In this situation, we know that
a) Neither the real nor the nominal exchange rate can change.
b) The real and nominal exchange rate must move together, changing by the same
percentage.**
c) The nominal exchange rate will fluctuate more widely than the real exchange rate.
d) The real exchange rate can change while the nominal exchange rate is constant.
e) The nominal exchange rate can change while the real exchange rate is constant.

2. In order for an individual to be indifferent between holding foreign or domestic bonds,


a) The Marshall-Lerner condition must hold.
b) The foreign and domestic interest rates must be equal.
c) The interest parity condition must hold.**
d) The expected rate of depreciation of the domestic currency is zero
e) Domestic exports must equal domestic imports.

3. An increase in the real exchange rate will cause


a) An increase in net exports
b) An increase in the quantity of imports**
c) An increase in output
d) A decrease in government spending
e) All of the above

4. The interest parity condition indicates that the domestic interest rate must be equal to
a) The foreign interest rate
b) The expected rate of depreciation of the domestic currency
c) The expected rate of appreciation of the domestic currency
d) The foreign interest rate minus the expected rate of appreciation of the foreign currency
e) None of the above**

5. Assume that the interest parity condition holds. Also assume that the U.S. interest rate is
8% while South African interest rate is 6%. Given this information, financial markets expect
the rand to
a) Depreciate by 14%
b) Depreciate by 2%
c) Appreciate by 2%**
d) Appreciate by 6%
e) Appreciate by 14%

6. As the economy moves up and to the left along the IS curve, which of the following will
occur when exchange rates are flexible?
a) Consumption decreases
b) The domestic currency appreciates
c) Investment spending decreases
d) All of the above**
e) None of the above

7. Suppose a country with a fixed exchange rate decides to reduce the price of its currency.
This change in policy is called
a) An appreciation
b) A depreciation
c) A peg.
d) A devaluation**
e) A revaluation

8. Under a crawling peg system, a country’s exchange rate


a) Is fixed except for small surprise changes
b) Changes at a predetermined rate against the dollar or some other major currency.**
c) Can fluctuate within a narrow band
d) Can change but the changes are kept secret from the public.
e) Is determined by the central bank of another country.

9. A common argument for fixed exchange rates is that they


a) Give central banks greater freedom in adjusting their economy’s level of output.
b) Forever free the central bank from having to adjust the exchange rate to fundamental
changes in the economy.
c) Make trade more costly and thus encourage domestic citizens to buy domestically
produced output.
d) All of the above
e) None of the above**

10. For this question, assume that there is a simultaneous tax increase and monetary
expansion. In a flexible exchange rate regime, we know with certainty that
a) The exchange rate will decrease and output will increase
b) The exchange rate will decrease.**
c) The exchange rate will increase and output will decrease
d) The exchange rate and output will both increase.
e) None of the above.
11. Given the following equation

Which statement(s) is/are correct?


i. An increase in the domestic interest rate leads to an appreciation in the exchange rate.
ii. An increase in the foreign interest rate leads to a depreciation in the exchange rate.
iii. An expected future appreciation of the exchange rate leads to an appreciation in the
current exchange rate.
A. i
B. ii
C. i and ii
D. i, ii, iii**
E. ii and iii
12. If the Marshall-Lerner condition holds then-----------in the exchange rate leads to-------- in
the net exports
a) a real appreciation, no change
b) a real depreciation, a decrease
c) a real appreciation, a decrease**
d) a real appreciation, an increase
e) an increase in the foreign output, a decrease