1

ECN391 2013-2014 TUTORIAL 3 sketch of answers

1. For countries with fixed exchange rates, payments deficits would be
self-correcting, if only governments would stop doing their darnedest to
prevent correction. Comment, and include how counterbalancing monetary
policy (sterilization) can prevent self-adjustment from occurring.
POSSIBLE RESPONSE: Under a payments deficit situation, the central bank would
have to intervene by selling foreign currency and buying domestic currency in the
foreign exchange market if it wishes to defend its fixed exchange rate. This would
have a tendency to shrink the domestic money supply. Without counterbalancing
(sterilization), the shrinking money supply would bid up domestic interest rates. The
rise in interest rates decreases GDP and imports, so the current account improves.
The rise in interest rates draws inflows of foreign capital (or reduces capital outflows),
so the financial account improves. For both of these reasons, the payments deficit
decreases, moving toward achieving external balance. However, the central bank
could sterilize the effects of intervention (as reduced GDP is not favorable result), for
instance, by buying domestic government bonds from the public. This would prevent
the money supply from decreasing. If the money supply does not decrease, then
domestic interest rates do not rise, and the adjustments of the current account and
financial account are cut off.




















2. Explain the effects of expanding the money supply on the balance of
payments of a country with fixed exchange rates.
POSSIBLE RESPONSE:
Y
i
IS
FE
LM
1

A
B
LM
0

2

Beginning from an external balance, an expansion in the money supply increases bank
liquidity. In the short run, as banks compete with each other to lend money, interest
rates are bid down. The fall in interest rates causes some holders of financial assets
denominated in the domestic currency to seek higher returns abroad. The international
capital outflow causes the financial account to deteriorate. The fall in interest rates
encourages interest-sensitive spending. The expansion in spending increases real
domestic product and income. The rise in income increases imports of goods and
services and worsens the current account balance. In addition extra spending put
upward pressure on prices. If prices and costs in the economy rise, then the countrys
international price competitiveness deteriorates and the countrys current account
worsens. Overall payments balance worsens and it puts downward pressure on the
exchange rate value of the domestic currency. The monetary authority has to act and
support. See Q1 for the supporting actions of the monetary authority.






















Y
i
IS
FE
LM
1

LM
0

A
B
3

3. Major shocks occasionally strike a countrys economy. List the types of shock
that may occur and discuss the effects of these exogenous changes on a
country that has a floating exchange rate.
POSSIBLE RESPONSE: There are two types of internal shocks that can affect a
countrys economy, domestic monetary shocks and domestic spending shocks. There
are two types of external shocks, international capital flow shocks and international
trade shock.

RELEVEANT DIAGRAMS ARE IN LECTRURE 7

Domestic monetary shocks shift the LM curve. A sudden decrease in money demand
resulting from a decreased desire to carry cash balances for precautionary purposes is
such an example. If the monetary shock tends to expand the economy, then the
domestic currency depreciates, further increasing domestic product.

Domestic spending shocks alter domestic expenditure and shift the IS curve. The
effect of this kind of shock on the exchange rate and therefore domestic product and
income depends on the relative slopes of the LM and FE curves because it matters
which changes more: international capital flows or the countrys current account.

International capital flows shocks shift the FE curve and occur because of changes in
investors perceptions of economic and political conditions in various countries. For
instance, an adverse shock to international capital flows, leading to capital outflow
from our economy, can occur if there is a sudden increase in foreign interest rates.
The capital outflow puts downward pressure on the exchange rate value of the
countrys currency and the currency depreciates. The depreciation improves the
international price competitiveness of the countrys products. The improvement in the
current account tends to increase its domestic product.

International trade shocks shift the IS and FE curves and cause the value of the
countrys current account balance to change. A sudden decline in foreign demand for
our exports or an increase in our taste for imported products would constitute such a
change. An adverse international trade shock reduces both the current account and the
countrys domestic product and income. As the current account worsens, the overall
balance of payments tends to go into deficit, and the countrys currency depreciates.
The improvement in price competitiveness leads to an increase in the countrys
exports and a decline in imports. Domestic product and income rise. The current
account improves, putting the overall payments balance back to zero.

4. Britain has instituted an expansionary fiscal policy to fight unemployment.
The pound is floating and there is a high degree of capital mobility.
a. If the exchange rate value of the pound remains steady, what are the
effects of the expansionary fiscal policy on British national product and
income? What is the effect on the British unemployment rate? Explain.
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b. Following the fiscal expansion, what is the pressure on the exchange rate
value of the pound? Explain.
c. What are the implications of the change in the exchange rate value of the
pound for British national product and unemployment? Does the
exchange rate change tend to reinforce or counteract the expansionary
thrust of British fiscal policy? Explain.


















POSSIBLE RESPONSE

a. If the exchange rate value of the pound remains steady, fiscal expansion
increases aggregate demand, so real product increases. The unemployment
rate in Britain tends to decrease as domestic production increases. Fiscal
expansion also increases domestic interest rates as the government borrows
more. IS to IS, Y
0
to Y
1
, interest rate increase too. A to B.

b. There are two opposing tendencies for the exchange rate value of the countrys
currency. The increase in income raises imports and worsens the current
account balance. The interest rate rise tends to draw a capital inflow. The
improvement in the financial account tends to strengthen the countrys
currency, but the deterioration in the current account tends to weaken it. Since
capital is highly mobile internationally, the capital inflow effect is large
enough to appreciate the countrys currency. Payments in surplus and it put
upward pressure on the exchange rate value of the British Pound. The Pound
appreciates. FE to FE


Y
i
IS
FE
LM
Y
0

IS
Y
2

A
B

Y
1

C
FE
IS
5

c. When the countrys currency appreciates, then the country loses price
competitiveness. The countrys exports decline and its imports increase. IS to
IS. The decline in the countrys current account reduces the expansionary
effects of the fiscal change on the countrys domestic product. That is, the
expansionary effects of the fiscal change on the countrys domestic product
are reduced by international crowding out. Y
1
to Y
2