Economics Advising Assignment

1-Can a country pursue, with a fixed exchange rate, an independent monetary policy to eliminate a recession? Explain and graph using the DD/AA model

Fixed Exchange Rate, which is also called pegged exchange rate, is such type of exchange rate system, in which the value of a currency is fixed to another currency/number of currencies. The objective of fixing the value of the currency, against another currency that is more stable. This monetary strategy has both advantage and disadvantage. It must also be recognized that when a currency is pegged to another currency, which is supposedly more stable, it becomes independent of market conditions. However, fluctuations in the value of the independent currency can strongly affect the value of the pegged currency, which is why the monetary policy of a country, which value of the currency is pegged with another country, cannot devise a potent monetary policy.

An Independent Monetary Policy aims to regulate capital controls, which makes a monetary policy effective; as it influences buying and selling of domestic currency. In case of a fixed exchange rate, domestic inflation cannot be affected. The primary purpose of monetary policy, during the recession, is to increase the general price level, which acts as an incentive for the companies/businesses. When monetary policy is not able to affect prices, its potency becomes limited (Siggel).

Explanation of Diagram: To stimulate the economy, the Central Bank has bought assets. It has a shift exchange rate to E² from E⁰, as AA¹ has moved to AA². However, this has not caused depreciation, as the currency is pegged.  It pushes Central Bank to sell Foreign Reserves, which again moves exchange rate to E⁰ from E² and AA² to AA¹. It depicts that monetary policy is ineffective under fixed exchange rate.

2-Suppose the Republic of Suffolk fixes the value of its currency, the Ram, to the dollar. In the U.S., the inflation rate is higher than the target inflation rate set by the Fed. The Fed then decides to reduce the money supply in the U.S. How will Suffolk be affected by this action by the Fed. Use the DD/AA model to explain and graph your answer.

When Fed adopts a contractionary monetary policy, it will sell assets (bonds), which will reduce the supply of money and money in circulation in the economy. It will depreciate the value of the American dollar, and because of this depreciation of the value of the dollar, the demand for it will also decrease, which will naturally appreciate the value of Ram. It will cause a high demand for the Ram, and for that reason, the domestic country will have to run a Balance of Payments deficit to maintain its fixed exchange rate. It will increase domestic interest rates, which will affect investment and inflation (Arnold).

The change is AA is caused by the increase in interest rate in International Market (increase in the interest rate in the U.S.), which has caused the AA curve to move upward to AA’. To address this parity, Suffolk will reduce the money supply, causing its interests to fall and supply to meet demand, which will bring AA’ to AA.

3-Based on your answers to question 2, can the government of Suffolk use fiscal policy to stabilize Suffolk’s real GDP? Explain and graph using the DD/AA model.

Stabilizing GDP is interpreted as sustainable economic growth or increase in national output. As it is already apparent that under fixed exchange rate, monetary policy is ineffective; therefore, the entire emphasis is on Fiscal policy (expansionary or contractionary) to affect the economy. To stabilize the economy, expansionary fiscal policy will be adopted.

Above is the graphical depiction of Fiscal stimulus, in which taxes have been reduced, and expenditure has been increased or expanded. It has caused appreciation initially; however, because the Central bank has to buy foreign assets with home currency, the new equilibrium point is 3.

4-Suppose the Republic of Suffolk fixes the value of the Ram to the dollar. The President of the Republic of Suffolk has decided to tariffs on U.S. imports to improve its current account. What will be the effect of this action on the economy? Using the DD/AA model to explain and graph your answers.

Fixed Exchange rates are used by emerging economies with the intention to keep inflation controlled. For instance, when a country has more exports than imports, the currency appreciates, which in the long run causes 1) demand for that currency and 2) inflation. It causes the exports to be more expensive than in the past, which makes it less competitive. If the Republic of Suffolk decides to impose a tariff on U.S. imports, this will affect imports and exports shortly; the exports will increase, and imports will decrease. It will result in appreciation of the currency and higher interest rates, which will push AA to AA’.

In future, it will make exports expensive and parity between value and interest rates of both currencies.

The demand for Ram, after the appreciation and higher interest rates, has pushed AA to AA’. However, this has also made exports expensive, which is why, to maintain fixed exchange rate, more of the foreign currency assets will be bought to bring AA’ to AA position.

Work Cited

Arnold, Roger A. Macroeconomics, Concise Edition. Cengage Learning, 2006. Print.

Siggel, Eckhard. Development Economics: A Policy Analysis Approach. Ashgate, 2005. Print.