Answer to Question #106756 in Macroeconomics for sara

Question

Consider the following short-run model of equilibrium in the foreign exchange market, money market, and goods market:

(1) R=R∗+Ee−EE,

(2) MsP=L(R,Y),

(3) Y=C(Y−T)+I+G+CA(q,Y−T).

All variables have the interpretation given in class (in particular, q=EP∗P is the country's real exchange rate).

Suppose that the government increases temporarily its spending by ΔG.

a) Explain how the endogenous variables of this model adjust to the new short-run equilibrium.

b) Suppose now that the government combines the temporary increase in government spending with a temporary increase in the money supply (both occurring at the same time). What can you say about the short-run response of output in this case compared to that in .a)?

c) Explain the intuition behind the difference in the response of output in questions .a) and .b).

Answer 1

a) Macroeconomic indicators in an open economy are largely related to the exchange rate. To analyze the influence of the exchange rate and other macroeconomic variables, we use one of the key macroeconomic models - the IS-LM model for an open economy (Mandell-Fleming model).

The increase in government spending causes an increase in aggregate demand - the IS curve shifts to the right to the position of IS2 (Fig. a). It can be seen that as a result, income grows and with it the interest rate r1 increases, because an increase in income increases the demand for money. At the same time, a higher interest rate attracts foreign capital to the country, which leads to the formation of an active capital account balance and, in general, the balance of payments.

The inflow of capital into the country gives rise to a tendency to increase the exchange rate of the national currency (Fig. b). The need to maintain the exchange rate at a fixed level e, requires the Central Bank to intervene in the foreign exchange market (buying foreign currency and selling national), which will lead to an increase in the money supply. An increase in money supply shifts the LM curve to the right, and the interest rate goes down. This process continues until the domestic interest rate is equal to the world.Thus, in a small open economy with a fixed exchange rate, income level Y as a result of a stimulating fiscal policy increases to a greater extent than in a closed economy. This is because the effect of the expansion of government spending on income is complemented by the effect of an increase in the money supply.

Fig/ Fixed-rate fiscal policy (a,b)

a) b)

b)The policy of increasing government spending while covering it with money growth (taking into account the fixed exchange rate) leads to an increase in the IS curve to the right, while the LM curve shifts to the right (due to the increase in money supply growth by the Central Bank).

France, 1981-1983 The socialist government came to power and tried to stimulate the economy, while the rest of the world was sliding into a deep economic downturn. The stimulating policy was to increase government spending with constant taxation and expansionary monetary policy (1/3 of the budget deficit was covered by an increase in money supply). Contrary to this, economic growth was only 1.8% in 1982 and 0.7% in 1983. The policy was right, if not for the deep economic crisis that overtook all of Europe. Due to the crisis in Europe, there was a decrease in the purchasing power of the population, the external interest rate also changed. As a result, economic growth was not so impressive, and over time, this policy had to be abandoned.As the domestic interest rate has increased compared to the world one, there is an influx of assets into the country, the balance of payments becomes positive, but this phenomenon is more likely connected with the capital account. The current account balance is likely to decrease, as the growth of government spending in the short term, coupled with an increase in money supply, will lead to an increase in imports to the country (the population has additional funds that they spend on all goods, including imported ones).

с)In the first case, there is an inflow of capital into the country, so a gradual increase in income occurs as a result of an increase in government spending. But, the Central Bank carries out interventions and the interest rate goes down. Those. with a fixed rate, this policy is very effective.

In the second case, the effect of capital consumption can be obtained when the population has additional funds that they spend on all goods, including imported ones, as a result of short-term public spending growth coupled with an increase in money supply.

And an increase in imports can lead to negative trends, namely a reduction in economic growth or slight economic growth (imports may exceed exports).