Economics 222
Sections A and C
Assignment # 4
Fall 1998
Instructors: Lawrence McDonough; Ryan Davies
(b) Show how the curve of the IS curve is related to the slope of
the I
curve.
(c) What is the economic interpretation of a relatively flat I
curve?
(b) Recall the definition of a real interest rate. What is the effect
on
the LM curve of an increase in the expected inflation rate? Explain.
(c) What does the price level have to do with the LM curve?
(d) Suppose that the stock market runs into a period of large price
variability in both stocks and bonds. Could this affect the LM curve?
Explain.
(b) Explain the "J-curve" effect of a decreased real exchange rate.
A diagram helps: IS-LM-FE diagram
- FE is not affected
- Direct effect: If G rises
then taxes must be raised at some time. In the long run, both C and S must
fall because disposable income falls. A decrease in S shifts the IS up.
(S moves left in the I and S equilibrium and r increases).
- Short run equilibrium:
IS-LM intersect at Y>Yfe and at higher r.
- Long run equilibrium:
Where Y>Yfe in short run, there is excess demand for goods which causes
wages and prices to rise. The increased price level reduces real money
supply and shifts the LM to the left until it intersects the new IS-FE
intersection. In the long run there is no net effect on the level of output
and employment.
Classical and Keynesian analyses differ on their view of the length of the short run. For Keynesians, the short run is sufficiently long to make the increased output a valued benefit. A Classical analysis would suggest a faster adjustment in prices and wages so that there are at best small benefits from such policies.
e = enom P/Pfor
enom = 0.63 ; Canadian good C$100, same US good US$70
e = (0.63*100)/70 = 0.9
The Canadian good can be traded for 0.9 units of the US good. (The value of Canadian good is traded for $US which is US$63. This buys 90% of the same good in the US market.)
(b) In response to a decrease in the exchange rate, it is possible that imports and exports take some time to adjust. Imports become more expensive and substitutes must be found. Exports also take time to adjust. However, the decrease in the exchange rate means imports cost more and revenues for exports fall. In the short run when prices move more than quantities, the increased dollar value of imports and decreased dollar value of exports may cause the NX to fall. When import and export quantities adjust, NX rises as predicted.
Flexible Rates:
- No change to FE
- Direct effect is to the shift LM right
Short Run Equilibrium: IS-LM intersection to right of FE. Y increases, imports increase, NX falls, r decreases, capital outflows increase, NX rises. NX may rise or fall, but the Y and r effects both increase the supply of $C to the international markets and causes enom to fall (e falls too).
Long Run Equilibrium: Y>Yfe causes P to rise and LM to shift (real Ms is falling) left until we return to the original equilibrium. The rise in P causes e to return to its original value, enom stays at it new lower level. Real Y is unchanged. (Money is neutral!)
Fixed Rates:
There are no effects running from r to NX because enom will be held fixed. As under flexible rates, the short run effect of increasing Y and decreasing r cannot occur - as soon as pressure mounts to reduce the exchange rate the monetary authorities must intervene to to keep it fixed. In this case the authorities have to reduce the supply of money. (The Bank of Canada intervenes by buying the excess supply of $C using foreign reserves. The $C are put in the Bank and this reduces the Ms in Canada.) A FE-IS-LM diagram or a FV-officail rate diagram could be useful in answering this question.
Monetary policy cannot be used for domestic purposes
under fixed exchange rates. It is used to fix the exchange rate. Under
flexible rates monetary policy can have real effects in the short run
(Classical
and Keynesian schools disagree on the length of the short run) but money
is neutral in the long run.