Question 1

A monetary shock to an economy with a fixed exchange rate regime will have a smaller impact on the domestic economy than will a comparable domestic spending shock.

Accepted Answer

A monetary shock, such as a change in interest rates or money supply, may not affect the exchange rate in a fixed exchange rate regime. Since the exchange rate remains constant, the impact on the domestic economy may be smaller compared to a domestic spending shock which directly affects the demand for goods and services in the economy. However, the extent of the impact would depend on the specific circumstances of the shocks and the nature of the economy.

Question 2

A central bank can sterilize the increase in the money supply that results from an intervention to defend a fixed exchange rate by selling domestic government bonds.

Accepted Answer

When a central bank intervenes to defend a fixed exchange rate, it typically purchases foreign currency, which increases the supply of domestic currency in circulation. If left unchecked, this can lead to inflation. To prevent this, the central bank can sell domestic government bonds to absorb the excess domestic currency and maintain the fixed exchange rate. This process is known as sterilization.

Question 3

The assignment rule says that, with fixed exchange rates, fiscal policy should be used to stabilize the balance of payments and monetary policy should be used to stabilize the domestic economy.

Accepted Answer

The assignment rule actually suggests the opposite: with fixed exchange rates, monetary policy should be used to stabilize the balance of payments, while fiscal policy should be aimed at stabilizing the domestic economy.

Question 4

With perfect capital mobility, the LM and FE curves are both horizontal.

Accepted Answer

If there is perfect capital mobility, it means that the interest rate is determined globally and is the same in all countries. This makes the LM curve perfectly elastic, meaning that a change in income will have no effect on the interest rate. As a result, the FE curve will also be horizontal because there is no exchange rate adjustment needed to balance out the differences in interest rates between countries.

Question 5

For a country with a fixed exchange rate and no sterilization: When the FE curve is flatter than the LM curve, a negative domestic spending shock to the IS curve creates a balance of payments deficit, which then causes the LM curve to shift to the left.

Accepted Answer

In a fixed exchange rate system with no sterilization, the exchange rate is fixed, so the foreign exchange (FE) curve is a horizontal line. A negative domestic spending shock shifts the IS curve to the left, which lowers domestic income and reduces imports. This creates a balance of payments surplus, which puts upward pressure on the exchange rate and causes the central bank to intervene by selling domestic currency and buying foreign currency to maintain the fixed exchange rate. As a result, the money supply contracts, shifting the LM curve to the left, which raises the domestic interest rate and further reduces domestic spending. If the FE curve is flatter than the LM curve, this means that a given change in the interest rate has a larger impact on the exchange rate, so the contractionary monetary policy required to defend the fixed exchange rate causes a larger reduction in output and a larger balance of payments deficit.

Question 6

The key to the assignment rule is that one powerful government policy tool can be used to achieve both external balance and internal balance.

Accepted Answer

The assignment rule suggests that each policy tool should be dedicated to a specific target, implying that one tool should be used for achieving external balance (e.g., exchange rate policy) and another for internal balance (e.g., fiscal or monetary policy), rather than one tool being used for both.

Question 7

"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.

Accepted Answer

The answer of "For countries with fixed exchange rates, payments...

Question 8

Describe the different types of internal shocks to an economy.

Accepted Answer

The answer of Describe the different types of internal shocks...

Question 9

According to the assignment rule, if a country has excessive inflation and a balance of payments surplus, it should ease monetary policy and tighten fiscal policy.

Accepted Answer

According to the assignment rule, if a country has excessive inflation and a balance of payments surplus, it should ease monetary policy and tighten fiscal policy. This is because excessive inflation is typically caused by an expansionary monetary policy, while a balance of payments surplus is typically caused by an expansionary fiscal policy. By easing monetary policy and tightening fiscal policy, the government can help to reduce inflation and improve the balance of payments.

Question 10

According to the standard IS-LM-FE model, a country with a fixed exchange rate can attain both internal and external balance by using an appropriate mix of monetary and fiscal policies, without resorting to devaluation or revaluation.

Accepted Answer

In the IS-LM-FE model, a country with a fixed exchange rate can achieve internal and external balance by adjusting fiscal and monetary policies. Fiscal policy can influence domestic demand and output, while monetary policy can affect interest rates and capital flows, allowing the country to maintain the fixed exchange rate without devaluation or revaluation.

Question 11

With fixed exchange rates, fiscal policy is more powerful with a high degree of capital mobility than with a low degree of capital mobility.

Accepted Answer

With fixed exchange rates, a high degree of capital mobility allows the government to implement fiscal policy without affecting the exchange rate. This is because capital inflows and outflows will offset any changes in the money supply caused by fiscal policy.

Question 12

Most countries are able to use sterilized interventions to run deficits and surpluses indefinitely.

Accepted Answer

While countries can use sterilized interventions to manage their exchange rates in the short term, running deficits or surpluses indefinitely can have long-term consequences on the economy such as inflation, decreased investment, and debt accumulation.

Question 13

Why is a depreciation or devaluation of the nation's currency unable to eliminate a trade balance deficit when the country's demand for imports and the foreign demand for the country's exports are both highly inelastic?

Accepted Answer

The answer of Why is a depreciation or devaluation of...

Question 14

Consider a country with a fixed exchange rate that is experiencing a deficit in it overall payments balance. Show graphically (using IS-LM-FE) and explain how a change in domestic monetary policy could attempt to quickly eliminate the payments deficit. What could be a possible threat to the economy due to the policy change?

Accepted Answer

The answer of Consider a country with a fixed exchange...

Question 15

A country begins with external balance (its official settlements balance is zero). Explain the effects of a shift by the country to an expansionary monetary policy on the balance of payments of the country. (Assume that the exchange rate is fixed, but do not consider any follow-on effects from defending the fixed rate.)

Accepted Answer

The answer of A country begins with external balance (its...

Question 16

With fixed exchange rates, external capital flow shocks have little impact on a country's economy.

Accepted Answer

With fixed exchange rates, external capital flow shocks can have a significant impact on a country's economy. If the capital flow shock is large and sustained, it can cause a balance of payments crisis, leading to a depletion of foreign exchange reserves and potentially a recession. Additionally, fixed exchange rates limit the country's ability to adjust to the shock through a devaluation of the currency, as the exchange rate is fixed.

Question 17

For a country with a fixed exchange rate and no sterilization: When the FE curve is steeper than the LM curve, a negative domestic spending shock to the IS curve creates a balance of payments surplus, which then causes the LM curve to shift to the right.

Accepted Answer

When the FE curve is steeper than the LM curve, an negative domestic spending shock to the IS curve will cause a decrease in output and a decrease in imports. This leads to a balance of payments surplus, as exports remain steady. The surplus creates an excess supply of the domestic currency in the foreign exchange market, which will cause the exchange rate to appreciate. This appreciation of the currency will shift the LM curve to the right, increasing output and lowering interest rates.

Question 18

As long as the FE curve is vertical, internal and external balance can be achieved by using the appropriate mix of monetary and fiscal policy.

Accepted Answer

When the FE curve is vertical, it indicates that the economy is at full employment, and output cannot be increased by domestic policy measures. Achieving both internal and external balance under these conditions would require adjustments in exchange rates or in foreign demand, not just domestic fiscal and monetary policies.

Question 19

The J-curve suggests a typical pattern for a country's trade balance after an abrupt depreciation or devaluation of the country's currency. What are the key factors behind this relationship? Explain.

Accepted Answer

The answer of The J-curve suggests a typical pattern for...

Quiz 23: Internal and External Balance With Fixed Exchange Rates