Macroeconomics (Fourth Edition)
4th Edition
ISBN: 9780393603767
Author: Charles I. Jones
Publisher: W. W. Norton & Company
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Chapter 20, Problem 10E
To determine
The policy trilemma.
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Following on from the analysis in the previous questions, an economist comes to the conclusion that the best option for policymakers in order to influence the economy would be to fix the exchange rate, keep control of money supply and allow free movement of capital. Would you agree with such a statement and why?
The incompatible trinity, also known as the trilemma, states that it is impossible to have all three of the following at the same time: a fixed foreign exchange rate, free capital movement (absence of capital controls), and an independent monetary policy. In this case, Brazil is sacrificing an independent monetary policy. This is because it is keeping its exchange rate fixed and allowing free capital movement, but it is not able to independently set its interest rate.
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Step 2
The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the price of a specific good in one country to the price of the same good in another country, expressed in the same currency. In this case, we are using the price of a Big Mac in China and the US to calculate the real exchange rate.
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First, we need to convert the price of a Big Mac in China to US dollars using the nominal exchange rate.…
You are the chief economic adviser in a small open economy with a floating exchange rate system. Your boss, the president of the country, wishes to increase the level of output in the short run in order to win reelection. Do you recommend using monetary or fiscal policy? Expansionary or contractionary? Use the Mundell-Fleming model to illustrate graphically your proposed policy. State in words what happens to real output, the nominal exchange rate, the level of consumption, the level of investment, and the net exports,
Chapter 20 Solutions
Macroeconomics (Fourth Edition)
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- The Policy Trilemma states that a country or a monetary union cannot pursue the following three policies at the same time a) free capital mobility, a flexible exchange rate, and an independent monetary policy. b) capital controls, a flexible exchange rate, and an independent monetary policy. c) capital controls, a fixed exchange rate, and an independent monetary policy. d) free capital mobility, a fixed exchange rate, and an independent monetary policy.arrow_forwardUsing the Mundell-Fleming model, explain whether you think a country should pursue an expansionary monetary policy whilst at the same time fixing its exchange rate.arrow_forwardGiven that the country has a floating exchange rate regime, what are the consequences of a policy mix consisting of simultaneous expansionary fiscal policy and restrictive monetary policy?arrow_forward
- Explain the links between an expansionary monetary stimulus and the foreign exchange rate.arrow_forwardIn the foreign exchange market, the supply curve for the dollar is upward sloping. That is, when the exchange rate (foreign currency per dollar) increases, the quantity of dollars supplied increases. Assuming actors have not yet had time to change their expectations about the future exchange rate, when the exchange rate increases, why is the supply curve of dollars in the foreign exchange market upward sloping? Foreign goods and services are less expensive to import. U.S. firms profit more by selling their goods and services domestically rather than selling to foreigners. The expected profitability of purchasing a dollar today to sell in the future rises. U.S. goods are less expensive for foreigners to purchase.arrow_forwardThe autonomous region of Catalonia has recently declared independence from Spain, and is looking for an exchange rate policy that would best fit their needs. The Catalans’ main goal is to stabilise the price level in the long-run, but constantly experience fluctuations in the price of foreign goods imported from Spain and other European countries. Would it be better for the Catalans to fix the exchange rate against the Euro, or to adopt a floating exchange rate? Justify your answer briefly.arrow_forward
- How is it necessary for a nation with a fixed exchange rate and open financial markets to renounce its independence in terms of monetary policy?arrow_forwardIn 1992, 18.6 million Canadians visited the United States, but only 11.8 million U.S. residents visited Canada. By 2002, roles had been reversed: more U.S. residents visited Canada than vice versa. Why did the tourism reverse direction? Canada didn’t get any warmer from 1992 to 2002 – but it did get cheaper. The reason is a large change in the exchange rate: in 1992 Canadian dollar was worth $0.80, but by 2002 it had fallen in the value by 20% to about $0.65. This means that Canadian goods and services, particularly hotel rooms and meals, were about 20% cheaper for Americans in 2002 compared to 1992. American vacations had become 20% more expensive for Canadians. Canadians responded by vacationing in their own country or in other parts of the world. Foreign travel is an example of a good that has a high price elasticity of demand: elasticity=4.1. One reason is that foreign travel is a luxury good for most people – you may regret not going to Paris this year, but you can live…arrow_forwardIn Krugman’s speculative attack model: a. What is the shadow exchange rate? Why does it increase over time? b. Why does the speculative attack occur at exactly the time the shadow exchange rate equals the fixed exchange rate? c. Why is there no jump in the exchange rate when the speculative attack occurs? d. How can the model be modified so a jump does take place when the speculative attack occurs?arrow_forward
- Suppose the Bank of Canada contracts the money supply in an effort to reduce aggregate demand by a particular amount, say $10 billion. If Canada was a closed economy, would the amount by which the Bank of Canada would need to reduce the supply of money to accomplish this goal be greater or smaller than the amount it would need to reduce the supply of money if Canada was a small open economy with a flexible exchange rate?arrow_forwardDoes an expectation of a stronger exchange rate in the future affect the exchange rate in the present? If so, how?arrow_forwardConsider Alpha, a country that is open to trade in goods and services with the rest of the world, where prices are fixed and in which only the goods market exists. In Alpha, the Marshall-Lerner condition doesn't hold — more precisely, net exports depend positively on the realexchange rate. Initially, the country is in goods market equilibrium, and trade is balanced. Having discussed which of the following three Figures provides a correct representation of the initial equilibrium in Alpha, describe the effects of a real appreciation. In particular, discuss if and how the various curves represented in the graph you have chosen will be affected, and explain the effects of the appreciation of the exchange rate on the equilibrium values of income, consumption, investment and net exports.arrow_forward
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