Xiaolu Xu s2145754
1a) With a fixed exchange rate, Y, M and i are endogenous in the three-equation
system. Production is determined by aggregate demand. Production is
determined by aggregate demand. The interest rate is determined by the interest
parity condition. Money supply is determined endogenously so that the LM
equation is satisfied for a given interest rate.
b) In the case Y, i and e are endogenous. Production is determined by aggregate
demand, the interest rate is determined by supply and demand for money, and
the exchange rate is determined by the interest parity condition.
c) In this case Y, M and e are endogenous. Production is determined by
aggregate demand, the central bank must adjust the money supply so as to
achieve the desired interest rate, and the exchange rate is determined by the
interest parity condition. The endogenous/ exogenous distinction relates to what
you are solving for with the equations, and thus what you are modelling. The
distinction has nothing to do with a variable being controlled or not controlled
by the central bank.
2) a) An increase in the money supply shifts the LM curve downwards, reducing
the interest rate, increasing output and depreciating the currency. This reduced
interest rate stimulates consumption and investment, and exchange rate
depreciation increases exports. As the Marshall-Lerner condition holds,
depreciation increases net exports. However, increased income results in higher
imports. Therefore, the overall effect on net exports is ambiguous.
b) Higher government spending leads to higher aggregate demand, in turn
leading to higher income. As income increases so too does demand for money,
increasing the interest rate and discouraging investment. The effect on
consumption is ambiguous: the increase in income stimulates consumption, but
the increase in the interest rate discourages consumption. A higher interest rate
also causes exchange rate appreciation, reducing net exports (all else equal). On
top of that, higher income implies higher imports, so net exports will decrease.
c) A decrease in foreign output reduces demand for exports, shifting leftwards
the IS curve. Lower aggregate demand lowers output and consumption,
reducing the demand for money and the interest rate. A lower interest rate
stimulates investment and leads to a depreciation of the exchange rate. If the
central bank then increases the money supply, it shifts LM curve rightwards,
lowering the interest rate and the exchange rate further, thus boosting
consumption, investment and net exports to the point where output is at its
original level. Lower interest rate implies higher investment and consumption.
Given output is unchanged, net exports must have decreased. Intuitively, the
decrease in e is not sufficient to make up for the initial drop in export demand.
Multiplier effect in an open economy - marginal propensity to save (mps) plus
the extra income going to the government marginal tax rate plus the amount
going abroad, the marginal propensity to import (mpm)
3) First consider a fixed exchange rate. With a credibly fixed exchange rate
there is no increase in the interest rate or the exchange rate and hence no
crowding out via these channels. Forward looking consumers will reduce
consumption because they know that they will have to pay for increased
government expenditure with higher taxes in the future, but this crowding out is
most likely only partial. So in this case, the statement is false. Second consider a
floating exchange rate. With a floating exchange rate and an inflation target, the
extent of crowding out depends on the reaction of the central bank. If
government expenditure increases, the central bank will most likely set a higher
interest rate than it would have otherwise set, and this will reduce investments
and lead to an appreciation of the exchange rate which has a negative effect on
exports. If the central bank was doing its job properly, then in the period just
before the fiscal intervention, the interest rate should have been set to put
aggregate demand at the level where the central bank wanted it to be. Thus, any
changes in AD resulting from the fiscal intervention should be offset to bring
AD back to the target level. So, the increase in government spending will be
offset by an equal decrease in private expenditure. In this case, the statement is
true.
