payments Excess demand (Expenditure>output) r > r Excess demand (Expenditure>output) r > r Excess supply (Expenditure<output) Excess supply

Transcription

1 Chpte Review Questions. The IS-- model defines six egions, eh oesponding to disequiliium in the money mket, goods mket nd/o the lne of pyments. Identify nd desie eh of these when pitl is pefetly moile, nd when pitl is pefetly immoile. Unde onditions of pefet pitl moility IS Zone : Blne of IS: Goods mket pyments < Exess demnd (Expenditue>output > Exess demnd (Expenditue>output > Exess supply (Expenditue<output > Exess supply (Expenditue<output < Exess supply (Expenditue<output < Exess demnd (Expenditue>output Defiit ( Suplus ( Suplus ( 4 Suplus ( 5 Defiit ( 6 Defiit ( : Money mket Exess supply (M S >M D Exess supply (M S >M D Exess supply (M S >M D Exess demnd (M S <M D Exess demnd (M S <M D Exess demnd (M S <M D

2 BT IS TB Zone : Blne of IS: Goods mket pyments < TB Exess demnd (Expenditue>output < Exess demnd (Expenditue>output < Exess supply (Expenditue<output > Exess supply (Expenditue<output > Exess supply (Expenditue<output > Exess demnd (Expenditue>output Suplus ( Suplus ( TB Suplus ( TB 4 Defiit ( TB 5 Defiit ( TB 6 Defiit ( TB : Money mket Exess demnd (M S <M D Exess supply (M S >M D Exess supply (M S >M D Exess supply (M S >M D Exess demnd (M S <M D Exess demnd (M S <M D. In floting exhnge te egime- to wht extent does the effetiveness of fisl poliy depend on the degee of pitl moility? When pitl is immoile, the lne of pyments position is ounted fo y the lne of tde. Beuse expots e detemined y oveses demnd, nd impots y domesti demnd, thee is level of inome TB whee the tde lne is in equiliium. The eonomy stts off t point, fisl expnsion shifts the IS uve to the ight nd s esult the eonomy moves to point, ut euse > TB = the tde lne hs now moved into defiit. This epesents n inese in the eltive demnd fo foeign ueny nd n inese in the supply of domesti ueny-

3 hene the exhnge te depeites. This howeve impoves ompetitiveness, leding to ise in expots nd fll in impots. The ISD uve nd the BT uve will theefoe shift to the ight nd the eonomy will settle t point. ( θ BT ( θ BT ( θ ( θ ( θ When pitl is pefet moile, the lne of pyments is in equiliium when the domesti inteest te equls tht oveses. Any devition would led to lge sle pitl flows in nd out of the ounty.. In this se fisl expnsion moves the lne of pyments into suplus. By ising the domesti inteest te intentionl investos will puhse domesti onds nd the

4 pitl ount will impove. Howeve, s esult the domesti exhnge te will ppeite, whih then owds out net tde etuning the eonomy to its oiginl position. When pitl is immoile, fisl expnsion (onttion genetes lne of pyments defiit (suplus, whees when pitl is pefet moile fisl expnsion (onttion moves the lne of pyments into suplus (defiit. Unde floting exhnge te egime, the exhnge te will djust to estoe lne of pyments equiliium. Theefoe, fisl poliy hs lge impt on the domesti eonomy when pitl is immoile, euse the poliy is einfoed the thn offset y exhnge te movements.. Using the IS-- model with low degee of pitl moility, wht will e the effets of the following?. A deteiotion in usiness optimism with fixed exhnge tes ( θ ( θ ( θ A fll in usiness optimism sees onttion in investment nd n inwd shift in the IS uve. At point the lne of pyments hs moved into suplus. Although the domesti inteest te hs fllen, whih enouges pitl outflows; these hve smll effet euse pitl moility is low. The fll in inome on the ovehnd edues the level of impots, nd this is eltively moe impotnt. The suplus on the lne of pyments highlights demnd nd supply movements in ueny mkets tht will led to n exhnge te ppeition. To pevent this, poliy mkes must expnd the money supply until the lne of pyments hs een

5 etuned to equiliium t point. The expnsion in the money supply edues inteest tes so enouges pitl outflows, ut lso ises domesti output inesing impots- oth effets offset the suplus nd the pessue fo ppeition.. An inese in the money supply with floting exhnge tes ( θ ( θ ( θ ( θ A monety expnsion shifts the uve outwds- this edues inteest tes nd ineses inome- oth of whih led to lne of pyments defiit. Given the defiit the exhnge te depeites, the impovement in ompetitiveness shifts oth the nd IS uves outwds. The new equiliium of the eonomy is t point.. A ise in txes with floting exhnge tes The ise in txes edues disposle inomes nd leds to fll in onsumption. Consequently, the IS uve shifts inwds nd output nd inteest tes fll. The fll in output lowes impots nd the lne of pyments moves into suplus. This suplus position eflets fll in the demnd fo oveses ueny, nd lso fll in the supply of domesti ueny. Both these movements led to n exhnge te ppeition, the ompetitiveness effets of whih shift oth the IS nd uves inwds. Theefoe, output flls futhe nd the eonomy moves to point.

6 ( θ ( θ ( θ ( θ ( θ d. fll in the money supply with fixed exhnge tes ( θ ( θ A onttion in the money supply, though omintion of ising the domesti inteest te nd eduing inome moves the lne of pyments into suplus nd eting pessue fo n exhnge te ppeition. This howeve, nnot e llowed to pesist if the fixed exhnge te is to e mintined, theefoe n offsetting monety expnsion is equied to etun the eonomy to its oiginl position.

7 4. Using the Mundell-Fleming model wht will e the effets of the following:. A oom in stok mket pies with fixed exhnge tes Ŷ An inese in stok mket pies will shift the IS uve outwds. This is euse it implies ising household welth nd onsumption, nd lso highe impliit vlution of fim investment oppotunities. As esult, the domesti inteest te ises moving the eonomy into position of lne of pyments suplus. To pevent the exhnge te fom ppeiting, the inteest te ise hs to e ommodted y n expnsion in monety poliy. Hene the eonomy will expnd even futhe. If we ssume tht the eonomy ws oiginlly t its full employment level, thee is now signifint positive output gp. Though upwd pessue on pies the eonomy will eventully etun to its full employment level of output, ut only in the long un.. n inese in ATM hges with floting exhnge tes This epesents n inese in the ost of liquidting finnil ssets (ssuming tht nk ounts py positive inteest tes. Theefoe, the demnd fo money t eh level of inome will inese putting upwd pessue on inteest tes. The uve will shift upwds. Upwd pessue on domesti inteest tes would move the lne of pyments into suplus y ttting inflows of foeign pitl. The exhnge te will then ppeite owding out net-tde, hene the IS uve flls nd the eonomy moves to point.

8 Ŷ As point is elow the full employment level of output the eonomy will eventully etun to point if thee is downwd djustment in wges nd pies.. A edution in money supply with fixed tes Ŷ This is simple. A monety expnsion ples downwd pessue on domesti inteest tes. This leds to wold-wide sustitution wy fom domesti into foeign onds, moving the lne of pyments into defiit nd putting depeitive pessue on the exhnge te. To mintin fixed exhnge te it is neessy fo the govenment to offset the oiginl monety poliy expnsion.

9 d. A edution in govenment spending with floting exhnge tes A fll in govenment spending shifts the IS uve inwds, edues domesti inteest tes, nd moves the lne of pyments into defiit due to net outflow of pitl. Howeve, the exhnge te will depeite, inesing ompetitiveness nd though n expnsion in net expots shift the IS uve k to its oiginl position. Ovell, the level of output emins unhnged, ut it now onsists of highe level of net expots nd lowe level of govenment spending. Ŷ 5. An open eonomy with zeo pitl moility onsists of the following omponents: C = ( T I = G = 00 T = 00 NX = S M = 500 M d = Whee is output, C is onsumption, I is investment, is the inteest te, T is the lump sum tx, G is govenment spending, NX is net expots, S in the nominl exhnge te (expessed in tems of foeign ueny/domesti ueny, M is the money supply nd M d is the demnd fo money.. Fo this eonomy deive the IS, nd BT shedules

10 The IS uve: = C + I + G + NX ( S = * 00 ( 0.6 = S 00 = S The uve: 500 = = The BT uve: 400 = 00S. Wht e the equiliium levels of inome nd inteest tes? Equiliium is whee IS, nd BT uves inteset. Fom the BT uve: NX = 0 S = Sustituting into the IS uve gives: = Intesetion with the uve: = = 500 = = 0.7 o 7.% ( = * = fom the IS uve ( = * = fom the uve

11 Moe dvned polems 6. How will hnge in the wold inteest te ffet the equiliium level of output when. pitl moility is low nd exhnge tes e fixed Even though pitl moility is low, ise in foeign inteest tes will led to n upwd shift in the shedule. This is euse t evey inome level the lne of pyments will e in slightly wose position, simply euse of net flow of pitl fom domesti to highe inteest eing foeign onds. Howeve, euse pitl moility is low this ffet might e smll, nd the upwd shift in the uve smll. ( θ ( θ ( θ Mintining the fixed exhnge te will equie onttion in domesti inteest tes. This will emove the lne of pyments defiit y eduing domesti inome nd theefoe impots, nd lso y eduing the inteest diffeentil etween domesti nd foeign onds. The eonomy will move fom point to point s onsequene. Note tht edution in wold inteest tes would hve the opposite effet, i.e. movement fom to.. pitl moility is pefet nd exhnge tes e flexile When pitl moility is pefet the lne of pyments e in equiliium wheneve domesti nd foeign inteest tes oinide. Theefoe, ise in the oveses inteest te will led to lne of pyments defiits s pitl flows out of domesti into highe inteest eing foeign onds.

12 This will then pompt n exhnge te depeition, whih will impove ompetitiveness nd shift the IS uve outwds. As net tde, nd output expnds the domesti inteest te will ise, this will ontinue until domesti inteest tes one gin equl those oveses. A fll in wold inteest tes would hve the opposite effet. The lne of pyments will move into suplus nd the exhnge te will ppeite until suffiient net tde hs een owded out so tht domesti nd foeign inteest tes oinide. Moe dvned questions 7. Domesti demnd (E is detemined in the following wy: E = (-T + G S Whee is output, T is lump sum tx, G is govenment spending, is the inteest te nd S the nominl exhnge te (foeign ueny/domesti ueny The money demnd eqution is M d = Initilly the govenment uns lned udget, so tht G = T = 00 Finlly, thee is pefet pitl moility nd wold inteest tes e * = 0... If the govenment deides to un fixed exhnge te egime so tht S =, wht level of money supply is equied?

13 Fist, define the IS uve using S = nd = 0.: ( * ( * ( = ( 0.75 = 650 = 6600 Fom the money mket: M = M ( ( = 0.5* =. Using you nswes in pt, wht will e the effets of n inese in govenment spending y 00. Will the effet on output e gete unde the fixed exhnge egime (S= o if the govenment llows the exhnge te to flot? Explin you nswe. An inese in govenment spending of 00 Mintining the fixed exhnge te t S =. ( * ( * ( = ( 0.75 = 750 = 7000 Note tht the multiplie is equl to 4. Money supply must ommodte fisl poliy so s to mintin = : M ( ( = 0.5* = ΔM = = 00 Wht if the exhnge te is flexile? Then S will hnge to owd out the fisl expnsion. Δ G = ΔNX

14 Δ NX = 400 * ΔS 00 = 400 * ΔS ΔS = = S 0.5 = = 5 The exhnge te ppeites y 5%. 8. Some new empiil eseh hs found tht the demnd fo money is ette funtion of disposle inome (-T thn tul inome. Wht would e the onsequenes of tx ut T, unde fixed nd floting exhnge te egimes? d 4 If the tnstions motive is n impotnt deteminnt of the demnd fo money, then money demnd my ise if disposle inome ises, even though tul inome hs not. A tx ut now hs n ffet on oth the IS nd uves. The IS uve shifts to the ight efleting highe onsumption. The uve shifts upwds euse the demnd fo money is now highe t evey level of output, nd hene, so e equiliium inteest tes in the money mket. As esult the eonomy moves fom to. If pitl moility is high the eonomy is now in position of lne of pyments suplus. Unde floting egime the exhnge te will ppeite nd the eonomy will move to point s net tde is owded out. Note tht tht output hs fllen elow its initil level euse the demnd fo money is highe t ll output levels, so tul output must fll futhe to edue inteest tes to wold levels.

15 Unde fixed egime monety poliy must expnd to ommodte the ise in domesti tes, so the eonomy moves fom point to point d. If pitl moility is low then the stoy is slightly diffeent. d TB Unde fixed exhnge te egime the eonomy moves fom point to point, whee the tde defiit equies monety onttion to pevent the exhnge te fom depeiting, so the eonomy ends up t point d. If exhnge tes wee floting then fom point the depeiting exhnge te would impove ompetitiveness nd expnd net tde- hene output will expnd to point. The only effet of the new money demnd funtion is tht in equiliium inteest tes will e slightly highe thn it would e othewise, efleting tht demnd fo money is gete t ll output levels. 9. Using the Mundell-Fleming model, exmine the impt of n inese in the isk pemium on domesti onds on the level of output unde fixed nd floting exhnge te egimes. Wht ftos e likely to influene the isk pemium? Unde pefet pitl moility the lne of pyments e in equiliium when domesti nd foeign inteest tes oinide, so =. If howeve isk pemium μ is pled on domesti onds then pt of the etun fo holding domesti onds is ompenstion fo thei eltive degee of iskiness. In this se, even if =, then isk djusted inteest tes imply tht μ < so thee would e outflows of pitl. Theefoe, in the pesene of isk pemium the lne of pyments e in equiliium when = + μ.

16 Theefoe, n inese in ounty s isk pemium will shift the shedule upwds. + μ ˆ In fixed exhnge te egime, the isk pemium y eting pitl outflows would put depeitive pessue on the exhnge te. Theefoe, mintining the fixed exhnge te would equie onttion in monety poliy nd n inese in domesti inteest te to + μ. In the shot un the eonomy will move fom to nd output will fll. Howeve, output will eventully etun to its full employment level t point if thee is downwd movement in pies tht ineses oth ompetitiveness nd the el money supply. + μ ˆ

17 In floting egime, pitl outflows led to depeition in the ueny. Net tde nd output theefoe expnd until domesti isk djusted inteest tes hve een diven up to wold levels. Hee, the eonomy expnds with output ising to. If output though hs isen ove its full employment level ising pies will eventully edue ompetitiveness nd ontt the el money supply- shifting the eonomy k to its full employment level. Thee e two min isks in holding issued in etin ounty. The fist is the isk of defult- tht is the issue of the ond will fil to py the onds yield on mtuity. The seond is isk tht the ueny in whih the ond is denominted in will fe lge depeition o devlution. In this se, when the etuns fom the ond e tnsfeed into othe uenies the deteiotion in the exhnge te will genete pitl losses. 0. Using the Mundell-Fleming model, with fixed nd floting exhnge tes, desie the effets of n inese in the full employment level of output. Wht e the likely deteminnts of the full employment level of output? ˆ ˆ An inese in the full employment level of output will see the eonomy simply move long the shedule to its new highe level of output. This is euse thee is negtive output gp whih leds to flling domesti pies so: Flling domesti pies imply el depeition in the exhnge te, this impoves ompetitiveness, enhnes net tde nd shifts the uve outwds.

18 Flling domesti pies ineses the el vlue of the money stok, shifting the uve downwds. The omintion of the movement in the nd uves t to keep inteest tes t the oveses te- hene the sme tnsition ous egdless of whethe the exhnge te egime is fixed o floting. The full employment level of output is likely to e detemined y nge of ftos tht influene: Lou podutivity- suh s edution nd tining, nd pitl stok levels. Lou ptiiption- inentives to wok nd not to wok Lou mket institutions- whih might ontol the degee of ompetition in the lou mket nd the mount of jo etion.. If monety poliy is neutl, e thee ny osts in fosking disetiony monety poliy to fix the exhnge te? The disdvntge of fixed exhnge te egime is tht monety poliy nnot e used to influene the domesti eonomy. Howeve, the neutlity gument implies tht money nnot influene the level of output in ny se. Ŷ Fo exmple, in floting exhnge te egime monety expnsion n inese the level of output y eduing domesti inteest tes nd depeiting the ueny. The quntity theoy of money though gues tht: Mv= Pˆ whee ˆ is the full employment level of output. The pedition f the Quntity Theoy is % Δ M = % Δ P,

19 so ny hnge in the money supply ineses pies in the sme popotion. Theefoe the el money supply (M / P is left unhnged, the uve fils to shift downwds nd the eonomy emins t the full employment output level. In this se the osts of opeting n dependent monety poliy ppe low. Monety poliy n only influene the eonomy if thee e igidities tht pevent the immedite djustment of pies, i.e. % Δ M > % Δ P. In whih se, hnges to the nominl money supply lso leds to movement in the el money supply nd hene the domesti inteest te. One it is epted tht the neutlity of money does not hold in the shot un, it is fee to influene the eonomy, t lest in the shot un. Long un monety neutlity is less ontovesil. If pies though do djust slowly the shot un my e defined s onsidele peiod of time. Also, one it is knowledged tht shot un neutlity fils it offes sope fo monety poliy to ete hysteesis type ffets on output.. With the use of onventionl IS-- model (i.e. no pie djustment identify the onditions whee fisl poliy is most effetive in influening the level of output in the eonomy. Unde floting exhnge te egime fisl poliy is most effetive when thee is zeo pitl moility. BT ( θ BT ( θ When pitl is immoile fisl expnsion pushed the lne of pyments (tde into defiit, nd hene the esulting exhnge te depeitions oost net tde. Howeve, when pitl is pefetly moile- the fisl expnsion ises inteest tes

20 nd moves the lne of pyments into suplus. The esulting depeition then owds out net tde. Unde fixed exhnge te egime the sitution is evesed. BT d When pitl is immoile fisl expnsion pushes the lne of pyments towds defiit. To pevent the exhnge te fom depeiting monety onttion is equied to owd out the inese in output. Howeve, when pitl is pefetly moile monety poliy must expnd to ommodte the fisl expnsion. Othewise the esulting lne of pyments suplus would led to n exhnge te ppeition. In n open eonomy the effetiveness of fisl poliy depends on the degee of pitl moility nd the exhnge te egime.. If exhnge tes e fee to flot, unde wht onditions does n expnsive monety poliy fil to inese the equiliium level of output? Unde floting exhnge te, thee e two situtions in whih n expnsiony monety poliy will fil to inese the level of output. - Investment is inteest inelsti nd thee is zeo pitl moility Equiliium in this se equies the BT nd shedules to lie on top of eh othe. Any shift in the uve will lte the level of peviling inteest tes, ut will hve no impt on the level of output.

21 Fist, euse investment is pefetly inteest inelsti. Seond, s thee is no (positive impt on output the eonomy emins in lne of tde- so thee will e no exhnge te movements. BT TB - liquidity tp Hee monety expnsion fils to put ny downwd pessue on inteest tes. The demnd fo money is pefetly elsti, so ny inese in the money supply simply dds to money holding euse uent tes e too low to enouge gents to puhse onds. If liquidity tp position hs een ehed, then monety poliy is lwys ineffetive in filing to shift the shedule nd hnge output.