Week 2

Question 1

Define internal balance (IB) and its two key objectives. Explain why each is crucial for maintaining a healthy domestic economy.

Answer 1

Internal Balance (IB): The goal of maintaining a stable and healthy domestic economy.

Two Key Objectives:

Full Employment: Ensures the economy produces at or near its productive capacity, improving citizens’ living standards.

Stable Prices: Creates a predictable economic environment, encouraging long-term investment and planning.

Question 2

What is external balance (EB), and how is it primarily measured? Why is achieving CA equilibrium desirable?

Answer 2

External Balance (EB): A country’s trade and financial interactions with the rest of the world, primarily measured by the current account (CA).

CA Equilibrium: Occurs when exports = imports, reflecting a sustainable trade and financial exchange level with other nations.

Desirability: Prevents unsustainable debt (CA deficits) or underutilization of resources (CA surpluses) in the long run.

Question 3

If a country faces both high unemployment and a current account (CA) deficit, outline the trade-offs involved in addressing these issues.

Answer 3

Reducing Unemployment: Increase absorption (A = C + I + G) through higher government spending (G) or encouraging private spending (C/I). However, this worsens the CA deficit by boosting imports.

Reducing CA Deficits: Decrease absorption by reducing government spending or private consumption, which reduces demand but can increase unemployment.

Trade-Off: Policy actions to improve one objective can negatively affect the other.

Question 4

How can exchange rate manipulation serve as an additional policy tool to address the trade-off between internal and external balance?

Answer 4

For Reducing Unemployment: Increase absorption (domestic demand through higher G or C).

For Reducing CA Deficit: Depreciate the domestic currency by increasing the real exchange rate (S). This makes exports cheaper for foreign buyers and imports more expensive for domestic buyers, boosting exports and reducing imports.

Question 5

Explain the historical example of the 1930s Great Depression and how policies to prioritize internal balance (IB) worsened external balance (EB).

Answer 5

Context: High unemployment during the Great Depression.

Policies: Governments used devaluations and trade restrictions to reduce unemployment by making exports cheaper and limiting imports.

Impact: These policies increased domestic production and employment but disrupted international trade and worsened international relations.

Conclusion: Prioritizing IB led to sacrificing EB.

Question 6

Discuss the Eurozone Sovereign Debt Crisis as an example of how external balance (EB) was prioritized at the expense of internal balance (IB).

Answer 6

Crisis Context: Southern European countries faced high debt and financial instability, threatening Eurozone stability.

Response: Northern European countries provided financial support to maintain EB by preserving the eurozone as a unified currency region.

Trade-Off: While this approach maintained EB by preventing economic collapse, it increased Northern Europe’s public debt and constrained fiscal policies, reducing IB stability.

Conclusion: Preserving the euro was essential for maintaining EB, even at the expense of IB stability.

Question 7

How did Brexit represent a decision to prioritize internal balance (IB) at the expense of external balance (EB)?

Answer 7

UK’s Prioritization: Brexit allowed the UK to reclaim control over its economy, borders, and laws, emphasizing national economic independence (IB).

Impact on EB: This led to trade disruptions with the European Union, reducing exports and increasing trade barriers.

Conclusion: While Brexit improved UK sovereignty, it negatively impacted trade relations, undermining external balance.

Question 8

How did the Trump administration’s “America First” policy represent an internal balance (IB) strategy, and what were the consequences for external balance (EB)?

Answer 8

Policy Focus: Emphasized prioritizing American jobs and reducing reliance on imports through trade protectionist measures.

Impact on EB:

Reduced international cooperation.

Disrupted trade flows and created trade conflicts (e.g., tariffs on China).

Conclusion: Although “America First” sought to protect IB by boosting domestic employment, it harmed EB by reducing trade interdependence and cooperation.

Question 9

How does the trade-off between achieving internal balance (IB) and external balance (EB) affect policymaking?

Answer 9

Trade-Off: Policies that focus on improving IB (e.g., full employment through higher spending) may worsen EB by increasing imports. Conversely, policies aimed at correcting CA deficits by reducing demand may lead to unemployment.

Real-Life Example 1: The 1930s Great Depression saw governments prioritizing IB by imposing trade restrictions, worsening EB.

Question 10

Define multiple policy instruments and explain their role in addressing both internal balance (IB) and external balance (EB) simultaneously.

Answer 10

Multiple Policy Instruments: These are tools used by governments or central banks, such as fiscal policy, monetary policy, and exchange rate adjustments, to simultaneously achieve objectives related to internal balance (full employment and stable prices) and external balance (sustainable current account).

Role: They help policymakers address the trade-offs between achieving internal economic objectives and maintaining stable international trade relations.

Example: A government might combine fiscal stimulus (increase in government spending) with currency depreciation to combat unemployment (IB) while addressing a current account deficit (EB).

Question 11

Suppose a country is facing both a high unemployment rate and a current account deficit. What two policy instruments could a government use to address these issues simultaneously? Explain how each would work.

Answer 11

Fiscal Policy (Increase Government Spending):
Boosting government spending (e.g., G) stimulates domestic demand, reduces unemployment by creating jobs, but may worsen the CA deficit by increasing imports.

Monetary Policy (Depreciate the Currency):
A weaker domestic currency (through lower interest rates or other monetary adjustments) makes exports cheaper and imports more expensive. This improves export competitiveness and reduces the current account deficit while limiting excessive reliance on imports.

Question 12

A country wants to reduce unemployment but is at risk of worsening its current account deficit. How can it use exchange rate policy as a multiple policy instrument to balance these goals?

Answer 12

Exchange Rate Policy (Depreciation): Depreciating the domestic currency makes exports more affordable to foreign buyers and imports more expensive for domestic consumers.

Effect on EB: Export demand increases, reducing the current account deficit.

Effect on IB: Employment improves as domestic industries become more competitive internationally.

Example: A country can implement monetary easing (lowering interest rates) to trigger a weaker exchange rate, boosting exports without relying solely on fiscal stimulus.

Question 13

What is the Swan diagram and what is its purpose in macroeconomic analysis?

Answer 13

Definition: The Swan diagram is a graphical model used to analyze the trade-offs between internal balance (IB) and external balance (EB) in an economy. It represents the interaction between real domestic absorption, real exchange rate, and output to determine equilibrium states.

Purpose: To show how changes in real exchange rates and domestic spending impact the trade-offs between maintaining full employment and achieving a balanced current account.

Real-life Example: A country with a trade deficit may use the Swan diagram to evaluate whether currency depreciation or changes in government spending can reduce the trade deficit without causing excessive unemployment.

Question 14

What does the upward-sloping EB line represent in the Swan diagram? How does it explain the relationship between real exchange rates and absorption?

Answer 14

EB Line (Equilibrium in External Balance): Represents combinations of real exchange rate (Sr) and real domestic absorption (A) that result in a balanced current account (CA = 0).

Upward Sloping: Indicates that a depreciation in the real exchange rate leads to increased imports and reduced exports (creating a CA deficit). To restore equilibrium, absorption must increase, which stimulates domestic demand and offsets the external imbalance.

Question 15

How does the downward-sloping IB line in the Swan diagram represent the trade-offs for achieving internal balance?

Answer 15

IB Line (Internal Balance Isoline): Represents combinations of real domestic absorption (A) and real exchange rate (Sr) that lead to full employment output (Y=Yfe, or full employment equilibrium).

Downward Sloping: Indicates that an appreciation in the real exchange rate (domestic goods become relatively more expensive) reduces exports and increases imports, thereby lowering net exports and demand for domestic goods. To maintain full employment, absorption must increase, offsetting this decline.

Question 16

If a country faces a CA deficit and unemployment at the same time, how can adjustments along the Swan diagram address these dual objectives? Provide policy examples.

Answer 16

Exchange Rate Depreciation: Depreciate the currency to make exports cheaper and imports more expensive. This would improve the current account by boosting exports and reducing imports.

Increase Domestic Absorption: Increase government spending (G) or support investment (I) to reduce unemployment by stimulating demand.

Trade-off: Increasing absorption could worsen the CA deficit by boosting demand for imports unless balanced by exchange rate adjustments.

Example: A coordinated monetary easing (lowering interest rates) to depreciate the exchange rate while combining fiscal stimulus to address unemployment.

Question 17

How does a change in the real exchange rate (Sr) impact full employment and absorption levels? Explain the trade-offs illustrated by the Swan diagram.

Answer 17

Impact of Real Exchange Rate Changes:
Appreciation (increase in Sr): Makes domestic goods relatively expensive, reducing exports and increasing imports, leading to a net decrease in demand for domestic goods and increasing unemployment.

Depreciation (decrease in Sr): Makes domestic goods relatively cheaper, boosting exports and reducing imports, increasing demand for domestic goods and improving employment but potentially worsening the CA.

Trade-off: Policymakers must balance exchange rate adjustments to maintain full employment without excessively worsening the CA.

Question 18

How does the trade-off between full employment and external balance manifest in the Swan diagram when the real exchange rate is adjusted?

Answer 18

Trade-off:
Depreciating the real exchange rate (moving along the EB curve) can improve the CA but may lead to reduced domestic demand and higher unemployment if it leads to higher inflation or less consumer spending.

Conversely, measures to boost domestic demand (increasing absorption) can improve internal employment (moving along the IB curve) but worsen the CA by increasing demand for imports.

The Swan diagram shows how a movement toward equilibrium requires careful navigation of these two competing objectives.

Question 19

What would happen to the equilibrium in the Swan diagram if a government implements austerity measures to reduce absorption? How would this affect both internal and external balance?

Answer 19

Effect on Absorption: Austerity reduces government spending, thereby reducing domestic absorption. This would reduce demand and shift the economy toward the IB line, likely reducing unemployment.

Effect on External Balance: Reduced absorption leads to reduced imports, improving the current account (shifting along the EB line toward balance).

Trade-Off: While reducing the CA deficit, austerity may increase unemployment by decreasing demand.

Question 20

Explain how the Swan diagram could illustrate the impact of Brexit on a country’s trade-offs between internal balance and external balance.

Answer 20

Brexit Example: The UK prioritized internal balance by regaining economic sovereignty, focusing on full employment, and reducing reliance on EU imports.

In the Swan diagram:

Brexit policies could shift the UK’s position toward higher absorption (increased domestic spending) to maintain employment, represented by movement along the IB line.

However, these policies negatively impacted external balance by reducing trade with the EU (movement along the EB curve toward imbalance).

Trade-Off: A clear example of how prioritizing one objective (IB) can lead to external imbalances (EB).

Question 21

What is the significance of being “above EB” and “above IB” in the context of the four quadrants? Explain using economic indicators.

Answer 21

Above EB (Equilibrium in External Balance): This indicates that CA>0, meaning the country has a current account surplus.

Above IB (Internal Balance): This implies that Y>Yfe, leading to inflationary pressures because the economy is operating above its full employment level.

Example: A booming economy with high exports may lead to a current account surplus (above EB), but excessive domestic demand could also lead to inflation (above IB).

Question 22

What is the Tinbergen rule, and how does it relate to achieving internal balance (IB) and external balance (EB)?

Answer 22

Tinbergen Rule: The number of policy instruments must be equal to or greater than the number of policy targets.

Relation to IB and EB:

To achieve both internal and external balance, two policy tools (monetary or fiscal) must be used simultaneously to target both objectives.

Real-World Example: During the Eurozone crisis, European countries used both fiscal stimulus (to address unemployment) and monetary policies like exchange rate adjustments to stabilize both employment and the current account.

Question 23

How does the elasticity approach differ from the Swan diagram in addressing external balance (EB) and internal balance (IB)?

Answer 23

Focuses solely on achieving external balance (EB) by adjusting exchange rates to address CA deficits.

Example: Depreciating the currency to make exports cheaper and imports more expensive.

Swan Diagram:

Provides a general approach by targeting both IB (full employment) and EB simultaneously.

Disadvantage of Swan Model:

Simplistic assumptions, neglects international capital movement, and does not differentiate monetary from fiscal policies.

Question 24

Why does the Swan model fail to account for international capital movements, and how does this affect its application?

Answer 24

Reason: The Swan model was developed during the 1950s, a period when international capital movements were less significant.

Impact: Modern economies have significant international capital flows, which affect exchange rates, investment, and monetary policy.

Consequence: Neglecting capital movement can lead to inaccuracies when applying the Swan model to contemporary economies.

Question 25

explain how the trade-off between achieving internal balance and external balance could lead to policy choices that favor one objective over the other.

Answer 25

Example: 2010s Eurozone Sovereign Debt Crisis: Southern European nations faced debt crises, high unemployment, and financial instability. Northern European countries prioritized external balance by maintaining the stability of the euro and supporting EU integration. This meant sacrificing some aspects of internal balance (unemployment reduction) to maintain economic stability and investor confidence.

Question 26

What are the disadvantages of relying solely on the Swan diagram when addressing an economy's internal and external imbalances?

Answer 26

Simplistic Assumptions: Underlying economic relationships are overly simplified. No Role for International Capital Movement: The Swan diagram doesn't account for capital flows, which can significantly influence exchange rates and policy outcomes. No Distinction Between Fiscal and Monetary Policies: The Swan model treats fiscal and monetary adjustments in aggregate rather than as distinct tools to affect aggregate demand and economic performance.

Question 27

What are the three market equilibria in the Mundell-Fleming model, and how do they interact?

Answer 27

IS Curve (Goods Market Equilibrium): Ensures equilibrium in the goods market with Y=C+I+G+CA. LM Curve (Money Market Equilibrium): Ensures equilibrium in the money market with L=M, where money demand depends on transaction and speculative purposes. BP Curve (Balance of Payments Equilibrium): Represents equilibrium in the foreign exchange market (CA+K=0), ensuring no net outflow or inflow in a country’s balance of payments. These curves intersect to determine equilibrium levels of income, interest rate, and exchange rate.

Question 28

What does the IS curve represent in the Mundell-Fleming model, and why is it downward sloping?

Answer 28

IS Curve Explanation: Represents equilibrium in the goods market where output (Y) equals aggregate demand (C+I+G+CA). Downward Sloping Reason: An increase in the interest rate reduces investment (I) and thus reduces overall demand, leading to lower equilibrium output (Y). Example: Higher interest rates make borrowing more expensive, leading to lower investment spending and therefore lower equilibrium income.

Question 29

What is the LM curve in the Mundell-Fleming model, and why is it upward sloping?

Answer 29

LM Curve Explanation: Represents equilibrium in the money market where money demand (L) equals money supply (M). Upward Sloping Reason: Higher income levels increase transaction demand for money, requiring higher interest rates to equilibrate the money market with a constant money supply. Transaction and Speculative Demand: Money demand depends on transaction needs and speculative balances.

Question 30

Explain how the BP curve represents equilibrium in the foreign exchange market. How is the slope of the BP curve influenced by capital mobility?

Answer 30

BP Curve: Represents balance of payments equilibrium (CA+K=0), meaning net capital flows are balanced with trade (current account). Slope of BP Curve: High Capital Mobility: Flatter BP curve because small changes in interest rates cause large capital movements. Low Capital Mobility: Steeper BP curve because capital is less responsive to interest rate changes. Perfect Capital Mobility: Horizontal BP curve as even small interest rate changes lead to large capital flows without requiring income adjustment. Perfect Capital Immobility: Vertical BP curve because capital flows are insensitive to interest rate changes—equilibrium depends only on changes in income (Y).

Question 31

How would an increase in capital mobility affect the shape of the BP curve? Explain with reasoning.

Answer 31

High Capital Mobility: Capital flows easily across borders in response to small interest rate differentials, making the BP curve flatter. This implies that only small changes in output (Y) are needed to restore equilibrium in response to shocks. Example: If capital can move freely in response to interest rate changes, a small change in r can attract or repel large flows of capital, making it easier to stabilize the economy without significant income adjustments.

Question 32

Suppose a country faces a sudden drop in exports leading to a shift in the IS curve. What would be the likely impact on equilibrium income and interest rates in the Mundell-Fleming model?

Answer 32

Shift in IS Curve: A reduction in exports lowers aggregate demand, shifting the IS curve leftward. Impact on LM and BP curves: With a leftward shift in IS, there is downward pressure on equilibrium income and interest rates unless monetary or exchange rate policies intervene. LM Curve Response: Given constant money supply, the LM curve intersects at a lower income and interest rate. BP curve adjustments: Capital mobility might exacerbate this by driving capital flows, depending on international response. The country would likely experience lower output and lower interest rates unless counteracted by policy adjustments.

Question 33

How would perfect capital immobility affect monetary policy decisions and the adjustment process in the Mundell-Fleming framework?

Answer 33

Capital Immobility: Capital does not respond to interest rate differentials, meaning changes in monetary policy (interest rate adjustments) will not directly affect capital flows. Adjustment Process: Equilibrium adjustments depend on changes in real income (Y) rather than changes in monetary variables. Policy effectiveness relies on shifts in the goods market or changes in real output rather than international capital flows. Example: If a country uses monetary stimulus (lower interest rates) under capital immobility, it affects domestic output but has minimal effects on capital flows.

Question 34

How would a government implement policies to restore BP equilibrium if it experiences a sudden capital outflow? Discuss monetary vs. fiscal policy responses.

Answer 34

Monetary Policy: Central banks could raise interest rates to attract capital by offering higher returns to investors. Fiscal Policy: Reducing government spending or increasing taxation could lower domestic demand, reducing imports and improving the current account. Exchange Rate Policies: Allowing the currency to depreciate can make exports more competitive, thus improving the current account and restoring BP equilibrium. Trade-offs: Monetary tightening reduces inflation but could slow economic growth, while fiscal adjustments might increase unemployment.

Question 35

Using the Mundell-Fleming model, explain how a sudden increase in international investor confidence could affect the equilibrium in the forex market (BP curve) under high capital mobility.

Answer 35

Investor Confidence Increase: Investors are more likely to invest in the country's assets. BP Curve Response: A capital inflow shifts the BP curve upward. Increased demand for the domestic currency leads to an appreciation of the exchange rate. Result: This reduces net exports by making domestic goods more expensive abroad, potentially causing a shift in the IS curve leftward unless policy offsets are implemented.

Question 36

Why does the LM curve slope upwards, and how does this relate to transaction and speculative motives in the demand for money?

Answer 36

Upward Slope Reason: As income (Y) increases, demand for money for transaction purposes rises. Since the money supply is constant, higher demand leads to higher equilibrium interest rates. Speculative Motive: Money balances held above transaction needs are speculative; investors demand higher returns (interest rates) to hold these balances during times of uncertainty. Example: An increase in income (Y) from higher consumer spending forces interest rates to rise to equilibrate the money market by reducing excess demand for money.

Question 37

What does the intersection of the IS and LM curves represent in the Mundell-Fleming model, and how does it relate to equilibrium?

Answer 37

The intersection of the IS curve (goods market equilibrium) and LM curve (money market equilibrium) determines the short-run equilibrium in the goods and money markets. At this intersection, the economy's output (Y) and interest rate (r) satisfy both markets simultaneously. Key Idea: However, this equilibrium does not necessarily represent full employment or external balance unless the BP curve (balance of payments) is also at equilibrium.

Question 38

What are the three main exogenous variables that can shift the IS, LM, or BP curves, and how do they affect equilibrium?

Answer 38

Fiscal Policy (Government Spending/Taxes): Increase in government spending (G) or decrease in taxes (T) → shifts IS curve to the right by increasing demand for goods and services. Monetary Policy (Money Supply): Increase in money supply (M) → shifts LM curve to the right by lowering interest rates and stimulating investment. Exchange Rate (S): Changes in exchange rate affect all three curves (IS, LM, BP) by influencing net exports, inflation, and external trade dynamics.

Question 39

How does an increase in government spending shift the IS curve in the Mundell-Fleming model, and what is its economic effect?

Answer 39

Mechanism: An increase in government spending raises aggregate demand (C+I+G+CA), leading to higher goods market demand. IS Curve Shift: The IS curve shifts to the right. Economic Effect: Output (Y) rises, interest rates may increase due to higher demand for credit, and investment could be stimulated. Example: A government launching a large-scale infrastructure project will lead to increased spending and demand for goods, shifting the IS curve.

Question 40

How does an increase in money supply (monetary policy) affect the LM curve in the Mundell-Fleming model?

Answer 40

Mechanism: An increase in money supply (M) lowers interest rates, encouraging borrowing and investment. LM Curve Shift: The LM curve shifts to the right because lower interest rates lead to greater liquidity, reducing the demand for money at any given level of income. Effect: Economic output (Y) rises as investment and spending increase. Example: When a central bank implements quantitative easing to combat a recession, it increases the money supply, shifting the LM curve.

Question 41

How does a change in exchange rate (S) impact the IS, LM, and BP curves?

Answer 41

IS Curve: Mechanism: Increase in S (depreciation of domestic currency) makes exports cheaper for foreigners, increasing net exports (CA) → IS curve shifts to the right. Example: A weaker domestic currency boosts competitiveness for local exports. LM Curve: Mechanism: A weaker currency raises prices (imported goods become expensive), reducing real money supply (M/P) → demand for money exceeds supply unless interest rates or output adjust. BP Curve: Mechanism: Currency depreciation leads to an increase in exports and a reduction in imports, improving the current account balance → BP curve shifts to the right.

Question 42

Explain how an increase in exchange rates (S) leads to both a shift in the IS curve and pressure on the LM curve.

Answer 42

Shift in IS Curve: A higher S makes local goods cheaper for foreign buyers, raising net exports and shifting the IS curve rightward. Pressure on LM Curve: A depreciated currency increases inflation expectations, raising the nominal price level (P). This reduces real money supply (M/P) unless interest rates are adjusted, leading to a contraction in liquidity demand unless output changes.

Question 43

If a country increases its exchange rate (S), how would the BP curve respond? Explain in terms of trade flows

Answer 43

Mechanism: An increase in S (domestic currency depreciation) makes exports more competitive and imports relatively expensive. Effect on BP curve: Exports increase and imports decrease. Current account improves, leading to a BP curve shift to the right. Example: A weaker domestic currency makes a country's goods cheaper abroad, boosting foreign demand for exports while reducing imports.

Question 44

How does the exchange rate (S) influence both monetary and fiscal policy responses in a country with an existing current account deficit?

Answer 44

Fiscal Policy: A government may try to cut deficits by lowering spending to reduce imports, but this could lead to higher unemployment. Monetary Policy: Monetary adjustments like raising interest rates could attract capital flows to balance the deficit but may increase unemployment or inflation. Exchange rate adjustment: Depreciation (raising S) can help balance trade by making exports competitive but risks increasing inflation. Trade-off Example: Balancing inflation, unemployment, and the current account simultaneously involves choosing between these policy tools.

Question 45

How does the Mundell-Fleming model explain the trade-offs between fiscal policy, monetary policy, and exchange rate adjustments in achieving equilibrium?

Answer 45

Fiscal policy can stabilize domestic output but risks worsening the current account deficit by increasing demand for foreign goods. Monetary policy can shift LM and influence demand but might lead to capital flight if interest rates attract speculative flows. Exchange rate adjustments can boost exports and reduce imports but may lead to inflation. Example: A country trying to reduce unemployment might raise government spending (shift IS right), but this could lead to a worsening external deficit unless offset by a depreciation in S.

Question 46

Discuss the challenges of achieving both internal balance (full employment) and external balance (zero balance of payments) simultaneously in the Mundell-Fleming framework.

Answer 46

Internal Balance (IB): Refers to achieving full employment by adjusting fiscal/monetary policies to maintain stable output. External Balance (EB): Achieving a zero current account balance via adjustments in trade competitiveness and capital flows. Policies like fiscal expansion might reduce unemployment but worsen the current account deficit by increasing imports. Conversely, policies aimed at reducing external deficits (via depreciation) could lead to higher inflation or unemployment. Real-life Example: The 2010s Eurozone debt crisis showed these trade-offs as nations balanced debt stabilization with maintaining trade flows.

Question 47

In a floating exchange rate system, the government increases spending to close a negative output gap (Y < Yf). Explain the sequence of events that occur and how the exchange rate responds.

Answer 47

The government increases spending (G) → this boosts aggregate demand (AD), shifting the IS curve right from IS to IS'. As Y rises, income also rises, leading to higher imports → this worsens the current account (CA) balance, creating a BoP deficit (BoP < 0). The floating exchange rate system reacts by depreciating the currency, making exports cheaper and imports more expensive. This leads to increased exports and decreased imports → improving the current account, eliminating the BoP deficit. As exports increase, output Y rises further, shifting the IS curve right again to IS'' and BP curve right to BP''.

Question 48

Using monetary policy to fine-tune output near full employment involves adjustments to the LM curve. Describe how the central bank achieves this and the expected effects on interest rates.

Answer 48

When Y is close to Yf, the central bank uses monetary policy to maintain equilibrium. The central bank reduces the money supply (M) slightly. This leads to a rise in the domestic interest rate (r), shifting the LM curve left to LM''. Higher interest rates slow inflationary pressures and moderate output growth as the economy approaches full employment.

Question 49

What is the macroeconomic trilemma, and how does it impact a small country trying to maintain a fixed exchange rate, perfect capital mobility, and an independent monetary policy?

Answer 49

The macroeconomic trilemma states that a country cannot simultaneously maintain: Fixed exchange rates Perfect capital mobility An independent monetary policy Example: A country cannot independently set interest rates without forex market intervention if it maintains a fixed exchange rate and allows perfect capital movement.

Question 50

What happens if a country increases its money supply in a system with perfect capital mobility while maintaining a fixed exchange rate? Discuss the sequence of events.

Answer 50

The central bank increases money supply (M) → shifts LM curve right to LM'. This leads to a decrease in domestic interest rates (r < r*). Capital outflows occur as investors move funds abroad due to better returns elsewhere. This leads to downward pressure on the domestic currency. To maintain the fixed exchange rate, the central bank intervenes by buying domestic currency with foreign reserves. This reduces the money supply back to its original level, shifting LM' back to LM, effectively undoing the monetary policy's effect.

Question 51

Explain the capital flow pressures that result if domestic interest rates (r) are greater than the global reference interest rate (r*), using an example.

Answer 51

If r > r*, investors find domestic assets more attractive. Capital inflows occur → this increases demand for the domestic currency. This creates upward pressure on the BoP. Example: If a country has high interest rates due to tight monetary policy, foreign investors will move their capital to this country, increasing demand for its currency.

Question 52

How does the European Exchange Rate Mechanism (ERM) highlight the challenges of pursuing an independent monetary policy under a fixed exchange rate system and perfect capital mobility?

Answer 52

The Netherlands pegged its currency to the Deutsche Mark (DM) under the ERM. If the central bank attempted to use monetary policy to stimulate the economy by increasing the money supply: Domestic interest rates would decrease. Capital outflows would occur, creating downward pressure on the Dutch currency. To maintain the fixed exchange rate, the central bank would intervene by purchasing Dutch currency with foreign reserves. This reverses the initial attempt to control monetary policy. This demonstrates why maintaining a fixed exchange rate with capital mobility limits a country’s ability to pursue independent monetary policy.

Question 53

What does a horizontal BP curve imply under perfect capital mobility, and how does it relate to interest rate differentials?

Answer 53

A horizontal BP curve indicates that for a given level of income (Y), any change in interest rate r would lead to capital flows. r = r* must hold to maintain BoP equilibrium under perfect capital mobility. If r < r*, capital flows outwards → BoP imbalance. If r > r*, capital flows inwards → BoP imbalance. Thus, the BP curve is horizontal because BoP depends solely on maintaining r = r* to balance capital flows.

Question 54

How does monetary policy fail to stimulate output if a country maintains both a fixed exchange rate and perfect capital mobility?

Answer 54

Suppose the central bank attempts to lower interest rates by increasing the money supply. This leads to r < r*, resulting in capital outflows. Capital outflows lead to downward pressure on the domestic currency. To maintain a fixed exchange rate, the central bank intervenes by purchasing domestic currency with foreign reserves. This intervention reduces the money supply back to its original level, negating the initial monetary policy change. This shows that maintaining both fixed exchange rates and perfect capital mobility prevents independent monetary policy from being effective.

Question 55

Why might increasing government spending lead to a worsening current account balance under a floating exchange rate system?

Answer 55

When government spending increases, aggregate demand rises, leading to higher output (Y) and higher income. This increases the demand for imports as consumers purchase more goods. The rise in imports worsens the current account (CA) balance and creates a BoP deficit. Under a floating exchange rate system, the currency depreciates in response to the BoP deficit, improving exports and reducing imports over time.

Question 56

What is the role of the central bank's monetary policy in managing inflationary pressures as the economy approaches full employment?

Answer 56

As output (Y) nears Yf (full employment), inflationary pressures can arise. The central bank reduces the money supply (M) slightly, shifting the LM curve left to LM''. This action raises interest rates, slows credit and spending growth, and moderates inflation. The goal is to achieve Y ≈ Yf while maintaining price stability.

Question 57

How would a country’s ability to use monetary policy independently be impacted if it chooses to maintain a fixed exchange rate and perfect capital mobility?

Answer 57

If a country maintains fixed exchange rates and perfect capital mobility, monetary policy would be constrained: An attempt to lower interest rates (to stimulate economic growth) would lead to r < r*, causing capital outflows. To counteract this and maintain the fixed exchange rate, the central bank would intervene by purchasing its own currency with foreign reserves. This would effectively reverse the monetary stimulus by tightening money supply again. The trilemma shows that monetary policy would lose autonomy under these conditions.

Question 58

If a country has perfect capital mobility but allows its exchange rate to float, can it pursue independent monetary policy? Explain.

Answer 58

Yes, if the exchange rate is floating, the country can pursue independent monetary policy because capital flows are not restricted. Mechanism: Changes in interest rates will impact capital flows, but a floating exchange rate allows these market adjustments without requiring central bank intervention. Example: A country can lower its interest rate to stimulate economic growth without the pressure of maintaining a fixed exchange rate.

Question 59

How does a country maintain fixed exchange rates while ensuring perfect capital mobility without compromising monetary policy independence?

Answer 59

It cannot. The macroeconomic trilemma shows that maintaining all three—fixed exchange rates, perfect capital mobility, and an independent monetary policy—is impossible. If a country tries to achieve all three, the central bank would have to frequently intervene to balance capital flows or exchange rates, thereby negating the goal of monetary independence. Example: ERM countries like the Netherlands struggled because fixing their exchange rates while allowing capital mobility undermined their ability to act independently through monetary policy.

Question 60

What would happen if a country adopts a floating exchange rate system and chooses to restrict capital mobility? How does this affect the macroeconomic trilemma?

Answer 60

If a country chooses floating exchange rates and restricts capital mobility, it can effectively pursue independent monetary policy without external market constraints. Effect: Capital mobility restrictions limit financial flows, allowing monetary policy actions (expansionary or contractionary) to focus solely on domestic economic goals without global pressure. However, restricting capital mobility can discourage foreign investment, leading to potential trade-offs for economic growth.

Question 61

Why is fiscal policy less effective under a floating exchange rate system with perfect capital mobility?

Answer 61

When government spending (G) increases: Aggregate demand (AD) rises, shifting the IS curve to the right. This leads to higher domestic interest rates (r) because the demand for money and investment increases. If r > r* (foreign reference interest rate), capital inflows occur as foreign investors buy domestic assets. This leads to an appreciation of the domestic currency (S down), making exports more expensive and imports cheaper. This reduces net exports, shifting the IS curve back to the left, counteracting the initial increase in output. Real-life example: A substantial fiscal stimulus at the European Union (EU) level can lead to the euro appreciating, reducing export competitiveness and diminishing the effectiveness of fiscal policy.

Question 62

How do price expectations and money demand influence the effectiveness of fiscal policy under a floating exchange rate with perfect capital mobility?

Answer 62

An appreciation of the domestic currency leads to: Lower imported goods prices → reduces inflationary expectations (π) → decreases money demand (L). A reduction in money demand decreases interest rates (r) and aligns r closer to r*. This means fiscal policy can be slightly effective because the initial stimulus effect can dampen as exchange rates adjust, and the money demand effect leads to lower interest rates.

Question 63

Discuss the UK’s experience with the ERM in the early 1990s and how it illustrates the macroeconomic trilemma.

Answer 63

The Exchange Rate Mechanism (ERM) aimed to maintain fixed exchange rates. Shock: German reunification in 1990 led to an increase in German interest rates (r*). This caused capital outflows from the UK to Germany, reducing the attractiveness of GBP. The Bank of England had to intervene by selling DM and buying GBP, leading to a reduction in money supply. This caused the LM curve to shift left, higher UK interest rates, and reduced output (Y). The UK’s experience shows how fixed exchange rates with perfect capital mobility and no independent monetary policy limit the ability of a country to manage its own domestic monetary conditions.

Question 64

What was the impact of Germany’s increased interest rates on the UK’s economy under the ERM framework?

Answer 64

German interest rates (r) increased*, leading to a differential (r > r*) with the UK. Capital outflows occurred as investors moved their money to Germany. This shifted the BP curve upward to BP'. To maintain the fixed exchange rate, the Bank of England (BoE) intervened by: Selling DM and buying GBP. This reduced the money supply, shifting the LM curve left in the IS-LM-BP model. Higher interest rates reduced borrowing and investment, leading to a decline in output (Y). This demonstrates how a country with a fixed exchange rate and perfect capital mobility loses control of monetary policy.

Question 65

Why did the Netherlands choose to remain in the ERM rather than following the UK in leaving the system?

Answer 65

The Netherlands prioritized exchange rate balance (EB) by maintaining its fixed exchange rate with the DM despite economic challenges. As a result: The Dutch experienced higher interest rates to maintain the peg. Output was lower because monetary independence was sacrificed to stabilize exchange rates. This demonstrates a trade-off under the trilemma: prioritizing exchange rate stability led to higher economic costs.

Question 66

Explain how capital flows impacted the UK’s ability to maintain the fixed exchange rate during the ERM.

Answer 66

With perfect capital mobility, any divergence between UK and German interest rates would lead to capital movements: German interest rates (r = Germany’s*) increased following reunification. Investors moved capital from the UK to Germany to benefit from higher returns. This led to capital outflows, reduced demand for GBP, and decreased reserves. To maintain the fixed exchange rate, the BoE had to buy GBP, depleting reserves and ultimately forcing intervention. Capital flows under perfect mobility destabilized the UK’s fixed exchange rate policy.

Question 67

Explain why fiscal policy is more effective at the national level within the Eurozone, but monetary policy is centralized and managed by the European Central Bank (ECB).

Answer 67

Fiscal Policy: Managed by national governments, allowing them to influence their own economic demand, employment, and growth within their borders. Monetary Policy: Controlled centrally by the ECB, as member states cannot set individual interest rates or money supply due to the fixed exchange rate and perfect capital mobility within the Eurozone. This assignment reflects the economic structure of the Eurozone, where centralizing monetary policy ensures uniform stability but reduces national monetary autonomy.

Question 68

Why is monetary policy ineffective for individual Eurozone member states under the framework of perfect capital mobility and a fixed exchange rate?

Answer 68

Perfect capital mobility means that capital moves freely across borders. A fixed exchange rate system ensures all Eurozone countries use a common currency (the euro). A member state attempting to change monetary policy (e.g., lowering interest rates) would lead to capital flows out of that state unless coordinated centrally. The ECB sets monetary policy for the entire Eurozone, so individual states cannot use independent monetary measures

Question 69

What role does the European Central Bank (ECB) play in the Eurozone monetary policy, and how does this differ from the fiscal policy powers of member states?

Answer 69

ECB's Role: Sets monetary policy (interest rates and money supply) for the entire Eurozone to ensure price stability and macroeconomic goals. Fiscal Policy: Managed by national governments, allowing them to control their spending and taxation to influence demand, employment, and economic growth in their own economies. This division reflects the structure of a shared monetary system where national governments retain fiscal flexibility, while monetary policy is uniformly managed centrally.

Question 70

Discuss the key economic challenge faced by Eurozone member states due to having a common currency but independent fiscal policies

Answer 70

Member states can adjust government spending (G) and taxes independently but cannot adjust their monetary policy. This creates imbalances because: A country with high debt may face limited options to respond to recessions since it cannot lower interest rates or devalue its currency. Economic shocks can affect different states unevenly, yet they share a common monetary policy through the ECB. Example: A weaker economy in one country (e.g., Greece) might struggle during a downturn without monetary policy tools.

Question 71

How does the structure of the Eurozone represent an example of the trade-offs involved in macroeconomic policy-making?

Answer 71

Monetary Policy Assignment: Managed centrally by the ECB for all Eurozone countries. This ensures consistency and stability across the Eurozone but reduces individual monetary flexibility. Fiscal Policy Flexibility: Retained by national governments, allowing individual states to respond to local economic challenges through taxation and spending. The trade-off arises because these arrangements limit independent policy tools while trying to balance the benefits of centralized monetary stability and local fiscal flexibility.

Question 72

What was the economic implication for countries in the Eurozone during the 2008 financial crisis given the constraints of a common monetary policy and national fiscal autonomy?

Answer 72

Monetary policy: The ECB could not tailor monetary responses for individual countries, as its policies applied uniformly across all member states. Fiscal policy: Countries with varying fiscal capacities struggled. Wealthier nations could implement stimulus measures, while weaker ones faced borrowing constraints. Example: Southern European nations like Greece faced debt crises because they couldn't devalue their currency or use independent monetary easing. This highlights the constraints of having a shared monetary system with independent fiscal policies.

Question 73

What does the Law of One Price (LOP) state, and under what market conditions does it hold true?

Answer 73

The Law of One Price states that in a competitive market with no transportation costs or trade barriers, identical goods will sell at the same price in different markets when expressed in terms of a common currency. This principle relies on arbitrage, which ensures price equalization across markets by correcting discrepancies. Conditions for LOP: Competitive market structure. Absence of transportation costs. Absence of trade barriers.

Question 74

What happens if the domestic price of a good is higher than the adjusted foreign price (i.e., Pg>S×Pg ∗) under the Law of One Price?

Answer 74

When Pg>S×Pg*, the good is cheaper in the foreign market. Consumers will increase demand for the foreign good. This leads to an increased demand for the foreign currency (to pay for foreign goods). The exchange rate S will rise as demand for the foreign currency grows. This process will restore equilibrium, aligning Pg with S×Pg*

Question 75

How does the Big Mac Index use the Law of One Price to compute a theoretical equilibrium exchange rate?

Answer 75

The Big Mac Index uses the price of a Big Mac as a standardized basket of goods across countries. The theoretical equilibrium exchange rate is expressed as: Sbm= Pbm /Pbm* ​Where: Sbm: Big Mac exchange rate (theoretical equilibrium exchange rate). Pbm: Price of a Big Mac in the domestic country. Pbm*: Price of a Big Mac in the foreign country. This allows the comparison of actual exchange rates with the Big Mac exchange rate to assess whether a currency is undervalued or overvalued.

Question 76

What does it mean if the actual exchange rate S is greater than the Big Mac exchange rate Sbm?

Answer 76

S>Sbm: The domestic currency is undervalued. It takes more domestic currency to buy the same foreign good. Implication: The exchange rate suggests the domestic currency is weaker than its theoretical value based on Big Mac parity.

Question 77

What does it mean if the actual exchange rate S is less than the Big Mac exchange rate Sbm?

Answer 77

S

Question 78

What are two reasons why the Law of One Price and the Big Mac Index do not perfectly capture real-world exchange rate adjustments?

Answer 78

Taxes and price discrimination: Variations in taxes and pricing strategies distort the perfect equality assumed by the LOP. Transaction costs: Costs associated with trading goods across borders (transportation, logistics, tariffs) prevent full arbitrage. These factors imply that while the LOP and Big Mac Index are useful, they are imperfect models.

Question 79

Critique the real-world application of the Big Mac Index as a measure of exchange rate valuation.

Answer 79

Strengths: It provides a simple, intuitive, and standardized way to evaluate exchange rate misalignments. It highlights long-term trends in currency valuation. Weaknesses: Taxes and price discrimination distort actual prices. Transaction costs limit arbitrage and equalization. The index assumes Big Macs are an ideal "basket of goods," but local preferences and market structures differ. Despite imperfections, the Big Mac Index captures key trends in exchange rates, suggesting that real-world factors influence currency valuation.

Question 80

What does the Purchasing Power Parity (PPP) condition imply about the exchange rate in the aggregate level, and how is it expressed?

Answer 80

PPP implies that the purchasing power of 1 unit of home currency is the same in both the home and foreign country when exchange rates are adjusted for price levels. It is expressed as: P=S×P* Where: P: Domestic aggregate price level. P* : Foreign aggregate price level. S: Exchange rate (domestic currency per unit of foreign currency). This indicates that if PPP holds, the ratio of home to foreign price levels determines the equilibrium exchange rate.

Question 81

Does PPP describe the actual observed exchange rate, or is it a theoretical construct?

Answer 81

PPP does not determine the actual observed exchange rate but provides the theoretical equilibrium exchange rate under the assumption that purchasing power is equal across countries. The actual exchange rate depends on other market factors, such as capital flows and monetary policy.

Question 82

What is the difference between Absolute PPP and Relative PPP?

Answer 82

Absolute PPP: States that the price levels must align across countries: P=S×P* However, this is difficult to verify because aggregate price levels are not directly observable. Relative PPP: Focuses on changes over time rather than absolute price levels, expressed by: dP/P = dS/S + dP*/P* This considers changes in inflation rates and exchange rates over time and can be observed using price indices (e.g., CPI).

Question 83

How can Relative PPP be used to analyze the depreciation of a home currency?

Answer 83

Relative PPP states: dP/P = dS/S + dP*/P* If domestic inflation (dP/P) is higher than foreign inflation (dP*/P*), the home currency will depreciate. This means dS/S>0, indicating that higher inflation reduces the purchasing power of the home currency.

Question 84

What are the primary reasons for deviations from PPP in the real world?

Answer 84

Trade costs and impediments: Transportation costs, tariffs, and other trade barriers make arbitrage difficult. Non-tradables vs. tradables: Non-tradables (e.g., services, real estate) do not follow PPP due to lack of international trade. Productivity differentials: Differences in labor productivity between rich and poor countries lead to deviations from PPP. These factors result in deviations, even though PPP provides a useful theoretical framework.

Question 85

How do trade costs affect the Law of One Price and the ability of PPP to hold?

Answer 85

Trade costs such as tariffs, shipping costs, and other transaction costs impede arbitrage. These costs prevent price equalization across borders, leading to deviations from PPP. If arbitrage becomes difficult or impossible, PPP does not hold.

Question 86

Why are non-tradable goods a limitation for PPP?

Answer 86

PPP relies on arbitrage mechanisms, which work for tradable goods but not non-tradable goods. Examples of non-tradables: services, housing, healthcare. Non-tradable goods have prices that are determined domestically, and these prices can differ significantly across countries, leading to deviations from PPP.

Question 87

Explain the Balassa-Samuelson effect and how it relates to deviations from PPP.

Answer 87

The Balassa-Samuelson effect shows that: Productivity is typically higher in tradable goods sectors in rich countries compared to poor countries. Workers in rich countries receive higher wages because tradable sector wages are relatively higher. Wages spill over to the non-tradable sector, leading to higher wages in non-tradables in rich countries. This leads to a higher aggregate price level in rich countries, even if prices in the tradable goods sector align across countries. Conclusion: Rich countries' higher productivity leads to higher prices in the non-tradable sector, creating a deviation from PPP.

Question 88

How does the inclusion of non-tradables affect CPI and its relation to PPP?

Answer 88

The Consumer Price Index (CPI) includes both tradable and non-tradable goods. Non-tradables introduce noise and distortions because their prices do not adjust through international arbitrage. As a result, CPI is weaker evidence for testing PPP compared to indices focusing primarily on tradable goods, such as PPI (Producer Price Index).

Question 89

What is the role of tradables in testing for PPP?

Answer 89

PPP works more effectively when focused on tradable goods, as arbitrage can align prices across countries through trade. Non-tradable goods are excluded because their prices are not subject to international trade. Indices like PPI (which focuses more on tradable goods) show stronger evidence supporting PPP compared to CPI.

Question 90

Why is PPP more valuable for analyzing long-term trends in exchange rates rather than short-term movements?

Answer 90

In the short term, monetary flows, speculation, and other capital market activities can cause deviations from PPP. In the long run, Relative PPP provides valuable insights because inflation trends tend to dominate short-term volatility.

Question 91

What would it mean for a country’s currency if the home country’s inflation rate was consistently higher than that of the foreign country?

Answer 91

A higher home inflation rate (dP/P > dP*/P*) would lead to: Home currency depreciation over time. Higher dS/S, as PPP predicts that higher inflation reduces the purchasing power of the home currency.

Question 92

If a country has productivity differentials compared to a richer country, how might these affect exchange rates?

Answer 92

Productivity differentials lead to differences in wages and prices in the tradable and non-tradable sectors. Richer countries have higher wages due to higher productivity, leading to higher aggregate price levels. These differences cause deviations from PPP, especially because wages adjust in the non-tradable sectors.

Question 93

What practical limitations exist in using PPP as a tool to forecast exchange rates?

Answer 93

Trade barriers, transaction costs, and non-tradable goods distort the assumptions behind PPP. Short-run factors like monetary policy, capital flows, and speculation influence exchange rates independently of PPP. PPP is more reliable in forecasting long-term trends rather than short-term exchange rate movements.