Problem Set Intermediate



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Problem Set

Intermediate Macroeconomics: MAKO 112
Problem 1

The European monetary union is the paradigm for the Mundell-Fleming model: member countries keep a fixed exchange rate in relation to each other, and there are very few restrictions to the movement of capital between countries. They all use the euro.


1. Briefly describe the set-up of the Mundell-Fleming model with price expectations and perfect capital mobility. Draw a diagram in the (ε, Y) space. In the case of fixed exchange rates, discuss the impact of monetary and fiscal policy. What is the cost in terms of policy alternatives of having a fixed exchange rate and perfect capital mobility? What are the policy options available for a country in the EU?
Solution

Equations:







Σχήμα 12.3 (Makniw, p. 478) shows the equilibrium in this model in the (ε, Y). Σχήμα 12.9 (Makniw, p. 490) shows that the monetary policy is completely ineffective. The pressure for depreciation resulting from the expansive policy requires a monetary intervention that offsets the initial policy. Fiscal policy is highly effective Σχήμα 12.8 (Makniw, p. 489). The cost of a fixed exchange rate and perfect capital mobility is to loose monetary policy. The only macroeconomic policy available is fiscal policy.
2. After German reunification in 1991, the West Germany government engaged in large expenditures in order to help East Germany. To avoid the increase in aggregate demand from translating into inflation, the Bundesbank simultaneously engaged in contractionary monetary policy. As Germany is the biggest economy in the euro area, assume that the Bundesbank is indeed able to affect the interest rate, while smaller countries like Portugal, take the interest rates as given. What was the effect of the German policies for Portugal?
Solution

The increase in German interest rates reduces investment in Portugal and induces pressure for depreciation that has to be offset by a contractive monetary policy. As a result, part of the cost of German reunification falls on Portugal


Graph (The effect of German reunification on Portugal)

Problem 2

The Asian currency crisis of 1997 led to the biggest recession in Asia in the past 50 years. This second problem looks at some of the issues for the case of Thailand.


1. Briefly describe the set-up of the Mundell-Fleming model with price expectations and perfect capital mobility. Draw a diagram in (ε, Y ) space.
Solution

Σχήμα 12.3 (Makniw, p. 478) shows the equilibrium in this model in the (ε, Y).
2. Currency crisis I: Thailand had a fixed exchange rate vis-a-vis the dollar until the Asian crisis in 1997. In a speculative attack, international investors started betting against the Thai Baht. Write down the uncovered interest parity (UIP) condition under rational expectations. Explain why the condition disappears when investors expect a devaluation. What is the monetary policy that the Thai Central Bank had to do to defend the exchange rate? What is the impact on output?

Solution

Uncovered interest parity





where is the expected devaluation or appreciation in real terms. The condition disappears if a devaluation is expected because under this condition rational investors would require a higher domestic interest rate in order to invest in domestic assets. We saw that if investors expect a devaluation, UIP implies that . Therefore, the analysis is similar to the case where the foreign interest rate goes up.
Graph (The effect of German reunification on Portugal)
There we can see that the Central Bank has to take contractive measures in order to keep the exchange rate. Therefore, the final result is a fall in output.
3. Currency crisis II: Defending the fixed exchange rate became untenable after several weeks, and the Thai government decided to abandon the fixed exchange rate. Show in (ε, Y) space what happened to output and the exchange rate once Thailand switched to the new exchange rate regime. Using the UIP, explain what happened to the Thai exchange rate.
Solution

Here the assumption is that the Thai Central Bank fixes a new fixed value for the exchange rate, which is lower than before. After doing so, the speculation disappears (the expected devaluation is 0), therefore the domestic interest rate has again to be equal to the foreign interest rate. We see that the effect of the devaluation is to decline the exchange rate (from to ), and given that the domestic interest rate is higher than , the Central Bank has to expand the monetary base in order to keep the new level of interest rate. The result is an increase in output.
4. The currency crisis led to a recession in Thailand. In order to restore the economy, the government asked the International Monetary Fund (IMF) for loans. The IMF forced the Thai government to reduce its expenditures and raise taxes. What happens to the interest rate, the exchange rate and output?
Solution

Fiscal policy is highly effective here, with fixed exchange rate. Increase of taxes and reduction of government expenditures both lead to a shift of the IS curve up to he left, because aggregate expenditure is reduced. Thus output goes down and the exchange rate remains constant.





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