In a context of perfect capital mobility, consider a simplified small open econo
ID: 1216406 • Letter: I
Question
In a context of perfect capital mobility, consider a simplified small open economy (for this economy we consider foreign GDP (Y F ), foreign price level (P F ), and the interest rate on international financial markets (r F ) as exogenous), modeled with the following equations: (1) C = 0.8(Y - T ) (2) T = T* = constant (3) I = -10,000r + 3,500 (4) G = G* = constant (5) M = 0.2Y + 1,000e (6) X = 0.2YF - 1,000e (7) MD /P = 0.4Y – 10,000r + 500 (8) MS = M* = constant (9) P = In particular: M: imports X: exports Y F : foreign income (or GDP) r F : foreign real interest rate e: exchange rate (defined as the quantity of foreign currency per 1 unit of national currency)
We study the effects of external shocks on this economy's equilibrium by considering two cases: - case (i): The economy has a fixed exchange rate regime; - case (ii) the economy has a floating exchange rate regime. For each shock (see questions 4. and 5. below), and for each type of exchange rate regime (i) and (ii), you will first analyze the initial effect of the external shock on the internal equilibrium and on the external equilibrium. Next, by presenting the dynamics of the curves (IS), (LM), and (IFM), you will explain the adjustments that follow an external disequilibrium. You will then compute all endogenous variables in the final equilibrium, which is reached when internal and external equilibria correspond.
4. Shock n° 1: the foreign interest rate is reduced to rF = 2%.
5. Shock n° 2: foreign income increases by 5%.
Explanation / Answer
Answer. The values of many variables are not given (T, G, M), so we are taking them as given in the question.
4. If the foreign interest rate is reduced to 2%.
In case of fixed exchange rate: If foreign interest rate reduced to 2% relatively to domestic interest rates, which means domestic interest rate is more than foreign interest rate or foreign interest rate is less than domestic interest rate, then the capital inflows will increase in the domestic country causes BOP surplus and it forces the currency to appreciate. But the exchange rates are fixed here, so Central bank will start selling domestic currency in the international market, thereby reducing the value of the domestic currency. So, exchnage rate falls to initial value that is set by the government. Overall effect will be a rise in income level.
If there is floating exchange rate: In case of floating exchange rate, exchnage rate is determined through market forces. So when the foreign interest rates becomes less as compared to domestic interest rates, then capital inflows increases, causes decrease in exchange rate (appreciating the value of domestic currency), as exchange rate increases net exports falls. So, overall effect will be domestic currency appreciaion and income level rises (because of capital inflows).
If foreign income increases by 5%.
In case fixed exchange rate: If foreign income rises by 5%, they will import more, it means our exports (domestic cuntry's exports) increases, so BOP account will have a surplus, this causes appreciation of domestic currency in the international market and exchnage rate falls. Central bank intervenes and starts selling the domesti currency in the international market and it causes exchange rate to return to its initial level which is set by the government. Overall effect will bbe a rise in national income and exports.
In case of flexible exchange rate: increase in foreign income causes our exports to increase, this causes a surplus in BOP account and exchange rate falls which means domestic currency appreciates. But as domestic currency appreciates net exports starts falling. So overall effect will be a rise in income level and decrease in exchange rates.