Chapter 19: Macroeconomic Policy and Coordination under Floating Exchange Rates Multiple Choice Questions 1.

Advocates of floating rate suggested it is favorable for economies for the following reasons EXCEPT that A. it discourages attack from foreign exchange speculators because of the fact that exchange rate ad ustment is immediate. !. it helps stabili"e the shock effect on unemplo#ment in case of economic changes such as fall in export demand. C. it automaticall# matches the domestic inflation with ongoing foreign inflation. $. it gives ever# countr# the opportunit# to guide its own monetar# conditions at home. E. it brings the %& exchange rate to the level predicted b# PPP without government polic# decisions. Answer' C (. )hich of the following is *+T a result of a temporary fall in foreign demand on one countr#,s exports under floating exchange rateA. The $$ curve shifts to the left due to reduction of aggregate demand. !. The AA curve shifts downwards due to reduction of mone# suppl#. C. Aggregate output falls $. The home countr#,s currenc# depreciates. E. *one of the above. Answer' ! .. )hich of the following /0 a result of a permanent fall in foreign demand on one countr#,s exports under floating exchange rateA. The $$ curve shifts to the left due to reduction of aggregate demand. !. The AA curve shifts upwards due to the increased expected long1run exchange rate. C. +utput is reduced b# a smaller degree compared to temporar# fall in demand. $. The home countr#,s currenc# depreciates. E. A%% of the above. Answer' E

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)hich of the following is4are /*C+&&ECT 5choose all that appl#6- An argument against floating exchange rates is that A. a fixed rate automaticall# prevents instabilit# in the domestic mone# market from affecting the econom# if shocks come from the home domestic mone# market. !. a fixed rate automaticall# prevents instabilit# in the econom# from output market shocks. C. a rise in mone# demand under a fixed exchange rate would have no effect on the exchange rate and output. $. a rise in mone# demand under a floating exchange rate would have no effect on the exchange rate and output. E. All of the above. Answer' !7 $

8.

The 9A/* reason behind the claims that the :;reater Autonom#: resulting from floating rates is illusionar# is that A. there is no evidence backing the claim. !. the exchange rate is an important macroeconomic variable and polic# makers will still consider its effect on the exchange rate. C. this claim is dependent on whom the government or polic#makers are. $. *one of the above. E. All of the above. Answer' !

3.

)h# will the :discipline: imposed on governments b# a fixed exchange rate disappear under a floating rate regime be a problemA. Tempted to follow over expansionar# fiscal polic# !. Tempted to follow over expansionar# monetar# polic# C. Econom# ma# go into an inflation bias $. 9a# tempt governments to stimulate the econom# to win an election E. A and C onl#. Answer' E

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9an# observers now think that the current exchange rate s#stem is A. badl# in need of reform. !. in a need for some mild reform. C. the right s#stem. $. ade=uate especiall# for developing countries. E. *one of the above. Answer' A

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;overnments would be able to use monetar# polic# to reach A. internal balance. !. external balance. C. internal and external balance. $. internal but not external balance. E. external but not internal balance. Answer' C

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Advocates of flexible exchange rates claim that under flexible exchange rates7 A. no countr# would be forced to import onl# inflation from abroad. !. no countr# would be forced to import onl# deflation from abroad. C. no countr# would be forced to import inflation and deflation from abroad. $. flexible exchange rates are not able to halt importing inflation from abroad. E. flexible exchange rates are not able to halt importing deflation from abroad. Answer' C

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Advocates of flexible exchange rates claim that under flexible exchange rates7 A. The Anited 0tates would now be able to set world monetar# conditions all b# itself. !. ;erman# would no longer be able to set world monetar# conditions all b# itself. C. The Anited Bingdom would no longer be able to set world monetar# conditions all b# itself. $. The Anited 0tates would no longer be able to set world monetar# conditions all b# itself. E. ;erman# would now be able set world monetar# conditions all b# itself. Answer' $

11.

Advocates of flexible exchange rates claim that under flexible exchange rates7 A. The Anited 0tates would no longer have the same opportunit# as other countries to influence its exchange rate against foreign currencies. !. The Anited 0tates would have the same opportunit# as other countries to influence its exchange rate against foreign currencies. C. The Anited Bingdom would not have the same opportunit# as other countries to influence its exchange rate against foreign currencies. $. ;erman# would not have the same opportunit# as other countries to influence its exchange rate against foreign currencies. E. *one of the above. Answer !

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0ome claim that the long and agoni"ing periods of speculation preceding exchange rate realignments would A. not occur under fixed1exchange1rate regime. !. not occur under floating. C. become more severe under currenc# board. $. become less severe under floating. E. *one of the above. Answer' $

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Advocates of floating rates pointed out that A. removal of the obligation to peg currenc# values would restore monetar# control to central banks. !. imposing of the obligation to peg currenc# values would restore monetar# control to central banks. C. removal of the obligation to peg currenc# values would restore fiscal control. $. imposing of the obligation to peg currenc# values would restore fiscal control. E. *one of the above. Answer' A

12.

Advocates of flexible exchange rates claim that under flexible exchange rates7 if the central bank faced unemplo#ment A. and thus wished to decrease its mone# suppl#7 there would no longer be an# legal barrier to the currenc# depreciation this would cause. !. and thus wished to expand its mone# suppl#7 there would no longer be an# legal barrier to the currenc# depreciation this would cause. C. and wished to expand its mone# suppl#7 there would no longer be an# legal barrier to the currenc# appreciation this would cause. $. and wished to decrease its mone# suppl#7 there now would be legal barriers to the currenc# depreciation this would cause. E. *one of the above. Answer !

18.

Advocates of flexible exchange rates claim that under flexible exchange rates7 a currenc#

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A. !. C. $. E.

appreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products. depreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# lowering the relative price of domestic products. depreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products. depreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# increasing the relative price of domestic products. *one of the above.

Answer C 13. Advocates of flexible exchange rates claim that under flexible exchange rates7 a currenc# A. depreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# increasing world demand for them. !. appreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# increasing world demand for them. C. appreciation caused b# decreasing the mone# suppl# would reduce unemplo#ment b# increasing world demand for them. $. appreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# increasing world demand for them. E. appreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# decreasing world demand for them. Answer A

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Advocates of flexible exchange rates claim that under flexible exchange rates7 a currenc#

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A. !. C. $. E.

depreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products and increasing the world demand for them. appreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products and increasing world demand for them. appreciation caused b# decreasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products and increasing world demand for them. appreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# lowering the relative price of domestic products and increasing world demand for them. appreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# lowering the relative price of domestic products and b# decreasing world demand for them.

Answer A 1>. Advocates of flexible exchange rates claim that under flexible exchange rates7 a currenc# A. depreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products and increasing the world demand for them. !. appreciation caused b# increasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products and decreasing world demand for them. C. appreciation caused b# decreasing the mone# suppl# would reduce unemplo#ment b# lowering the relative price of domestic products and decreasing world demand for them. $. appreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# increasing the relative price of domestic products and decreasing world demand for them. E. appreciation caused b# increasing the mone# suppl# would increase unemplo#ment b# lowering the relative price of domestic products and b# decreasing world demand for them. Answer A

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Advocates of flexible exchange rates claim that under flexible exchange rates7 the central bank of

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A. !. C. $. E.

an overheated econom# could cool down activit# b# increasing the mone# suppl# without worr#ing that undesired reserve inflow would undermine its stabili"ation effort. a cooled econom# could cool down activit# b# contracting the mone# suppl# without worr#ing that undesired reserve inflow would undermine its stabili"ation effort. an overheated econom# could cool down activit# b# contracting the mone# suppl# without worr#ing that undesired reserve inflow would undermine its stabili"ation effort. an overheated econom# could cool down activit# b# contracting the mone# suppl# without worr#ing that undesired reserve outflow would undermine its stabili"ation effort. *one of the above.

Answer' C (@. Advocates of flexible exchange rates claim that under flexible exchange rates7 A. enhanced control over fiscal polic# would allow countries to dismantle their distorting barriers to international pa#ments. !. reduced control over monetar# polic# would allow countries to dismantle their distorting barriers to international pa#ments. C. enhanced control over monetar# polic# would allow countries to increase their distorting barriers to international pa#ments. $. enhanced control over monetar# polic# would allow countries to dismantle their distorting barriers to international pa#ments. E. *one of the above. Answer' $ (1. !# the end of the 1?3@,s7 man# countries felt that the# were importing inflation from A. The Anited 0tates. !. ;erman#. C. Crance. $. Dapan. E. The Anited Bingdom. Answer' A

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)hich one of the following statements is true-

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A. !. C. $. E.

!# devaluing its currenc#7 that is7 b# lowering the domestic currenc# price of foreign currenc#7 a countr# can insulate itself completel# from an inflationar# increase in foreign prices. !# revaluing its currenc#7 that is7 b# increasing the domestic currenc# price of foreign currenc#7 a countr# can insulate itself completel# from an inflationar# increase in foreign prices. !# revaluing its currenc#7 that is7 b# lowering the domestic currenc# price of foreign currenc#7 a countr# cannot insulate itself completel# from an inflationar# increase in foreign prices. !# revaluing its currenc#7 that is7 b# lowering the domestic currenc# price of foreign currenc#7 a countr# can insulate itself completel# from an inflationar# increase in foreign prices. *one of the above.

Answer' $ (.. )hen all changes in the world are due to A. fiscal policy7 purchasing power parit# holds true in the long run. !. monetary policy, purchasing power parit# does not hold true in the long run. C. monetar# polic#7 purchasing power parit# holds true in the long run. $. monetar# polic#7 purchasing power parit# holds true even in the short run. E. *one of the above. Answer' C (2. Ander purchasing power parit#7 A. exchange rates immediately move to offset exactly national differences in inflation.. !. exchange rates eventually move to offset exactly national differences in inflation.. C. exchange rates eventually move to offset to some extent national differences in inflation.. $. exchange rates eventually move to offset exactly national differences in unemployment. E. *one of the above. Answer' A

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Ander purchasing power parit# 5PPP67 if A.0. monetar# growth leads to a long1run doubling of the A.0. price level7 while ;erman#,s price level remains constant7 PPP predicts that the A. long1run $9 price of the dollar will be doubled. !. long1run $9 price of the dollar will be halved. C. long1run $9 price of the dollar will remain the same. $. short1run $9 price of the dollar will be halved. E. *one of the above. Answer' !

(3. A. !. C. $. E.

Ander a flexible exchange rate regime7 a mone#1induced decrease in A.0. prices causes an immediate appreciation of the foreign currencies against the dollar. increase in A.0. prices causes an immediate appreciation of the foreign currencies against the dollar. increase in A.0. prices causes an eventual appreciation of the foreign currencies against the dollar. increase in A.0. prices causes an eventual depreciation of the foreign currencies against the dollar. *one of the above.

Answer' ! (<. Ander !retton )oods7 A. an# foreign countr# cannot devalue its currenc# against the dollar in conditions of Efundamental dise=uilibriun.F !. an# foreign countr# could devalue its currenc# against the dollar in conditions of Efundamental dise=uilibrium7F but the s#stem,s rules did not give the Anited 0tates the option of devaluing against foreign currencies. C. an# foreign countr# could devalue its currenc# against the dollar in conditions of Efundamental dise=uilibrium7F and the s#stem,s rules did give the Anited 0tates the same option of devaluing against foreign currencies. $. The Anited 0tates could devalue its currenc# against the foreign currencies in conditions of Efundamental dise=uilibrium.F E. *one of the above. Answer' !

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The $$ schedule shows A. interest rate and output pairs for which aggregate demand e=uals aggregate output. !. exchange rate and output pairs for which aggregate demand e=uals aggregate output. C. exchange rate and output pairs for which aggregate suppl# e=uals aggregate output. $. interest rate and output pairs for which aggregate suppl# e=uals aggregate output. E. *one of the above. Answer' !

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The AA schedule shows A. interest rate and output pairs at which the foreign exchange market and the domestic mone# market are in e=uilibrium. !. exchange rate and output pairs at which the foreign exchange market and the domestic mone# market are in e=uilibrium. C. interest rate and output pairs at which onl# the foreign exchange market is in e=uilibrium. $. exchange rate and output pairs at which onl# the foreign exchange market is in e=uilibrium. E. *one of the above. Answer' !

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Ander flexible1exchange1rate regime7 the response of an econom# to a temporar# fall in foreign demand for its exports is A. the currenc# appreciates7 and output falls. !. the currenc# depreciates7 and output falls. C. the currenc# depreciates7 and output increases. $. the currenc# depreciates7 and output remains constant. E. *one of the above. Answer' !

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Ander fixed1exchange1rate regime7 the response of an econom# to a temporar# fall in foreign demand for its exports is A. the currenc# appreciates7 and output falls. !. the currenc# depreciates7 and output falls. C. the currenc# remains the same7 and output decreases. $. the currenc# depreciates7 and output remains constant. E. *one of the above. Answer' C

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Comparing fixed to flexible exchange1rate regimes7 the response of an econom# to a temporar# fall in foreign demand for its exports is A. output actuall# falls less under fixed rate than under floating rate. !. output actuall# falls more under fixed rate than under floating rate. C. output actuall# remains the same under fixed rate than under floating rate. $. /t is impossible to tell. E. *one of the above. Answer' !

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The case against floating exchange rates is because of A. discipline and destabili"ing speculation and mone# market disturbances. !. in ur# to international trade and investment. C. uncoordinated economic policies. $. the illusion of greater autonom#. E. All of the above. Answer' E

.2.

Ander a fixed exchange rate regime7 an increase in real mone# demand A. moves the AA curve to the right. !. leaves the AA curve unchanged. C. moves the AA curve to the left. $. moves the $$ curve to the right. E. *one of the above. Answer' !

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Ander a flexible exchange rate regime7 an increase in real mone# demand A. moves the AA curve to the right. !. moves the AA curve to the left. C. leaves the AA curve unchanged. $. moves the $$ curve to the right. E. moves the $$ curve to the left. Answer' !

.3.

The effects of an increase in real mone# demand on an econom# A. are a powerful argument in favor of fixed rates. !. are a powerful argument in favor of flexible rates. C. show the difficulties in determining which exchange rate is better. $. are a powerful argument in favor of fixed rates onl# in the short run. E. are a powerful argument in favor of fixed rates onl# in the long run. Answer' A

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/f most of the shocks that buffet the econom# come from the home mone# market7 then A. a fixed1exchange1rate regime is better than a flexible exchange rate regime. !. a flexible1exchange1rate regime is better than a fixed exchange rate regime. C. which s#stem is chosen is not important. $. a fixed1exchange1rate regime is better than a flexible exchange rate regime onl# in the short run. E. a flexible exchange rate regime is better than a fixed exchange rate regime onl# in the short run. Answer' A

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/f most of the shocks that buffet the econom# come from the home mone# market7 then A. a fixed1exchange1rate regime is better than flexible exchange rates. !. a flexible1exchange1rate regime is better than a fixed1exchange1rate regime. C. which s#stem is chosen is not important. $. a fixed1exchange1rate is better than a flexible1exchange1rate regime onl# in the long run. E. *one of the above. Answer' A

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The effects of a decrease in export demand A. are a powerful argument in favor of fixed rates. !. are a powerful argument in favor of flexible rates. C. 0how the difficulties in determining which exchange rate is better. $. are a powerful argument in favor of fixed rates onl# in the short run. E. are a powerful argument in favor of fixed rates onl# in the long run. Answer' !

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/f most of the shocks that buffet the econom# come from the output market shocks7 then A. fixed exchange rates are better than flexible exchange rates. !. flexible exchange rates are better than fixed exchange rates. C. which s#stem is chosen is not important. $. fixed exchange rates are better than flexible exchange rates onl# in the short run. E. flexible exchange rates are better than fixed exchange rates onl# in the short run. Answer' !

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/f most of the shocks that buffet the econom# come from the home mone# market7 then A. fixed exchange rates are better than flexible exchange rates. !. flexible exchange rates are better than fixed exchange rates. C. which s#stem is chosen is not important. $. fixed exchange rates are better than flexible exchange rates onl# in the long run. E. *one of the above. Answer' !

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+ne should expect the forward exchange market A. to flourish under a fixed exchange rate regime. !. to flourish under a flexible exchange rate regime. C. to flourish the same under either a fixed or a flexible exchange rate regime. $. to flourish under a fixed exchange rate regime in the short run. E. *one of the above. Answer' !

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$ue to macroeconomic interdependence between large countries7 the effect of a permanent monetar# polic# expansion b# Gome is as follows' Gome output A. rises7 Gome,s currenc# depreciates7 and Coreign output ma# rise or fall. !. falls7 Gome,s currenc# depreciates7 and Coreign output ma# rise or fall. C. rises7 Gome,s currenc# appreciates7 and Coreign output ma# rise or fall. $. rises7 Gome,s currenc# depreciates7 and Coreign output rises. E. *one of the above. Answer' A

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$ue to macroeconomic interdependence between large countries7 the effect of a permanent fiscal expansion b# Gome is as follows' Gome output A. falls7 Gome,s currenc# appreciates7 Coreign output rises. !. rises7 Gome,s currenc# appreciates7 Coreign output rises. C. rises7 Gome,s currenc# depreciates7 Coreign output rises. $. rises7 Gome,s currenc# appreciates7 Coreign output decreases. E. *one of the above. Answer' !

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The ;roup of Cive 5;186 countries includes A. the Anited 0tates7 !ritain7 Crance7 ;erman# and Dapan. !. the Anited 0tates7 !ritain7 Crance7 ;erman# and /tal#. C. the Anited 0tates7 !ritain7 Crance7 ;erman# and &ussia. $. the Anited 0tates7 !ritain7 Crance7 ;erman# and Canada. E. All of the above on a rotating basis. Answer' A

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The Pla"a Accord of 1?>8 announces that the A. ;18 countries will intervene in the foreign exchange market to bring about a dollar appreciation. !. ;1 < countries will intervene in the foreign exchange market to bring about a dollar depreciation. C. ;18 countries will intervene in the foreign exchange market to bring about a dollar depreciation. $. ;1< countries will intervene in the foreign exchange market to bring about a $9 depreciation. E. *one of the above. Answer' C

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Essay Questions 1. )h# would #ou suggest to a government to use a floating exchange1rate regime-

Answer'

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Floating Exchange Rate1 an exchange rate in which central banks do not intervene in foreign exchange market to fix rates. Reasons for Cloating Exchange &ates' I 9onetar# polic# autonom# I 0#mmetr# I Exchange rates as automatic stabili"ers

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)h# would #ou suggest to a government *+T to use a floating exchange1rate polic#-

Answer'

There are some who argue against floating exchange rates for the following reasons' I $iscipline I $estabili"ing speculation J mone# market disturbances I /n ur# to international trade J investment I Ancoordinated economic policies I /llusion of greater autonom#

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Present the case for floating exchange rates. 1. 9onetar# polic# autonom# ;overnments would be able to use monetar# polic# to reach internal and external balance. *o countr# would be forced to import inflation and deflation from abroad. 0#mmetr# The Anited 0tates would no longer be able to set world monetar# conditions all b# itself. The Anited 0tates would have the same opportunit# as other countries to influence its exchange rate against foreign currencies. Exchange rates as automatic stabili"ers. The long and agoni"ing periods of speculation preceding exchange rate realignments would not occur under floating.

Answer'

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Present the case against floating exchange rates. 1. (. .. 2. 8. The discipline imposed on individual countries b# a fixed rate would be lost. $estabili"ing speculation and mone# market disturbances. /n ur# to international trade and investment. Ancoordinated economic policies. The illusion of greater autonom#.

Answer'

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EAnder floating rates7 the econom# is more vulnerable to shocks coming from the domestic mone# market.F $iscuss.

Answer' The statement is true. Ander floating rates7 a rise in real domestic mone# demand causes income to fall and domestic currenc# to appreciate. /f the rise in real domestic mone# suppl# is permanent7 it will lead eventuall# to a fall in the home price level. Ander a fixed exchange rate7 the change in real mone# demand does not affect the econom# at all. To prevent the home currenc# from appreciating7 the central bank bu#s foreign reserves with domestic mone# until the real mone# suppl# rises b# an amount e=ual to the rise in real mone# demand. This intervention has the effect of preventing an# change in output or the price level. 3. Gow did countries use their polic# tools to regain internal and external balance after the first oil shock of 1?<.-

Answer' As the recession deepened over 1?<2 and earl# 1?<87 most governments shifted to expansionar# fiscal and monetar# policies. The +PEC countries could not raise spending =uickl# enough to match their increased real income and were running a substantial current account surplus in 1?<8 and 1?<3. <. EEven under flexible exchange rate regime7 governments could not be indifferent to the behavior of exchange rates and inevitabl# surrendered some of their polic# autonom# in other areas to prevent exchange rate movements the# viewed as harmful to their economies.F $iscuss.

Answer' True. +ne example is Kolker in +ctober 1?<? decreasing the A.0. mone# suppl# to halt further weakening of the dollar.

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/magine a world with two large countries7 Gome and Coreign. Evaluate how Gome,s macroeconomic policies affect Coreign. Compare the small and the large countr# casesL consider both permanent monetar# and fiscal policies.

Answer' *ote that since the two countries are large7 neither countr# can be thought of an# longer as facing a fixed external interest rate or a fixed level of foreign export demand. Consider onl# permanent shifts. A permanent monetar# expansion b# Gome7 in the small countr#,s case7 would lead to currenc# depreciation and increase in output7 interest rates also falling. )hen the Gome econom# is large7 the same would happen7 but now the rest of the world is affected too. !ecause Gome is facing real currenc# depreciation7 Coreign must be experiencing a real currenc# appreciation. This makes foreign goods relativel# expensive and thus reduces its output. Gowever7 this increases Gome,s output7 since Gome,s imports will rise. Thus7 it is not clear what will happen to Coreign output. *ote that Coreign output can rise onl# if the Coreign nominal interest rate rises too7 and it can fall onl# if Coreign nominal interest rate falls. This is because the foreign market e=uilibrium is' 9M4PM N %5&M7 OM6. 5!ecause in this exercise 9M is not changing and PM is stick# b# assumption and thus fixed in the short run.6 *ow consider a permanent expansionar# fiscal polic# in Gome. /n the small countr# case7 a permanent fiscal expansion would cause a real currenc# appreciation and a current account deterioration that would full# nullif# an# positive effect on aggregate demand. /n effect7 the expansionar# impact of the Gome fiscal ease would leak entirel# abroad. This is because the counterpart of Gome,s lower current account balance must be a higher current account balance abroad. /n the large countr# case7 Coreign output still rises because Coreign,s exports become relativel# cheaper when Gome,s currenc# appreciates. /n addition7 now some of Coreign,s increased spending increases Gome exports7 so Gome,s output actuall# increases along with the output of Coreign. Gome,s nominal interest rate must rise and Coreign,s interest rate rises at the same time as well.

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)hat has been learned since 1?<. with regard to the experience with floating exchange rate regime-

Answer' 1. 9onetar# polic# autonom#' Oes7 however7 floating rate did not insulate countries completel# from foreign polic# shock. /n addition7 no central bank can be indifferent to its currenc#,s value in the foreign exchange market7 thus the name Edirt# floatF rather than Eclean float.F (. 0#mmetr#' *o7 the dollar remains an important currenc#L the $9 and the #en have gained importanceL the !ritish pound declines in importance. .. The exchange rate as an automatic stabili"er' ;ood performance of the flexible regimesL man# believe that7 otherwise7 ma or realignments of exchange rates should have taken place. Gowever7 some sectors suffered7 such as agriculture. 2. $iscipline' $id countries abuse the autonom# afforded b# floating rates/nflation rates did accelerate after 1?<. 8. $estabili"ing 0peculation' Cloating exchange rates have exhibited much more da#1to1da# volatilit# than the earl# advocates of floating would have predicted. Gowever7 exchange rates are assets prices and so considerable volatilit# is to be expected. +ver the long run7 the# do not seem to support the notion of destabili"ing speculation. 3. /nternational trade and investment' Critics of floating claimed that international trade and investment would suffer as a result of the increased uncertaint#. This prediction was certainl# wrong. The use of forward markets and other derivatives expanded dramaticall#. 0till7 some economists disagree about the benefit to international trade. <. Polic# coordination' Cloating exchange rates have not promoted polic# coordination. 1@. ECixed exchange rates are not even an option for most countries.F $iscuss.

Answer' $urable fixed exchange rate arrangements ma# not even be possible unless countries are willing to maintain strict controls over capital movements 5as China does67 or7 at the other extreme7 move to a shared single currenc# with their monetar# partners 5as in Europe6. Even a countr# following prudent monetar# and fiscal policies is not safe from speculative attacks on its fixed exchange rate.

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Quantitative !raphing Pro"lems 1. Ase the follwing table to illustrate the importance of macroeconomic polic# coordination. 0how that the two governments would have been happier if the two of them had adopted looser monetar# policies7 but given the policies that the other government did adopt7 it is not in the interest of an# individual government to change its course. Assume that each countr# wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemplo#ment. This means that each countr# maximi"es the expression' minus the change in inflation divided b# the change in unemplo#ment7 i.e.7 the inflation reduction per point of increased unemplo#ment.

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Answer' +ne needs to translate the outcomes of the table above into polic# pa#offs. Assume that each countr# wishes to get the biggest reduction in inflation rate at the lowest cost in terms of unemplo#ment. This means that each countr# maximi"es minus the change in inflation divided b# the change in unemplo#ment7 the inflation reduction per point of increased unemplo#ment. This leads to the following table. The outcome of this game is on the lower right hand side of the table7 where the two countries use ver# restrictive monetar# policies rather than cooperating and using the somewhat better restrictive policies for both of them.

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Ase the $$ I AA model to examine and compare the response of an econom# under fixed and floating exchange1rate regimes to a temporar# fall in foreign demand for its exports.

Answer' The $$ curve shifts to the left. )hen the exchange rate floats7 because the demand shift is assumed to be temporar#7 it does not change the long1run expected exchange rate and so does not move the asset market e=uilibrium schedule AA. Thus7 E rises7 i.e. the currenc# depreciates and output falls. Ander a fixed exchange rate polic#7 the central bank must prevent the currenc# depreciation that occurs under a floating rateL thus7 it bu#s domestic mone# with foreign currenc#7 reducing the domestic mone# suppl# and shifting the AA to the left and down. E will remain constant and output will fall.

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Ase the $$ I AA model to examine and compare the response of an econom# under fixed and floating exchange1rates regimes to a permanent fall in foreign demand for its exports.

Answer' The $$ curve shifts to the left. Ander a flexible exchange1rate polic#7 the expected exchange rate Ee also rises and AA shifts upward and to the right. Thus7 a permanent shock causes a greater depreciation than a temporar# one. Ander a fixed exchange1rate polic#7 the central bank must prevent the currenc# depreciation that occurs under a floating1rate regimeL thus7 it bu#s domestic mone# with foreign currenc#7 reducing the domestic mone# suppl# and shifting the AA to the left and down. E will remain constant and output will fall. Ander a fixed exchange1rate regime7 a fall in export demand if permanent have led to a situation of Efundamental dise=uilibriumF calling for a devaluation of the currenc# or a long period of domestic unemplo#ment as export prices fell. Ancertaint# about the government,s intention would have encouraged speculative capital outflows7 further worsening the situation b# depleting central bank reserves and contracting the domestic mone# suppl# at a time of unemplo#ment. 2. Asing the AA I $$ framework7 compare the effects of a rise in real domestic mone# demand under flexible and under fixed exchange1rate regimes. Answer' Ander floating7 a rise in real domestic mone# demand shifts the AA curve leftward and down7 income falls and E decreases7 i.e.7 the domestic currenc# appreciates. /f the rise in real domestic mone# suppl# is permanent it will lead eventuall# to a fall in the home price level. Ander a fixed exchange rate7 the change in real mone# demand does not affect the econom# at all. The AA curve does not move. To prevent the home currenc# from appreciating7 the central bank bu#s foreign reserves with domestic mone# until the real mone# suppl# rises b# an amount e=ual to the rise in real mone# demand. This intervention has the effect of keeping the AA in its original position7 preventing an# change in output. This is a powerful argument in favor of fixed rates if most of the shocks that buffet the econom# come from the home mone# market.

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8. )hat are the outcomes of the following games7 assuming the max1min criteria is used%et' the following expression denoted b# X' minus the change in inflation divided b# the change in unemplo#ment7 i.e.7 the inflation reduction per point of increased unemplo#ment. And let the corresponding expression for the foreign countr# denoted b# XM7 i.e.7 minus the change in inflation in Coreign divided b# the change in unemplo#ment in Coreign7 i.e.7 the inflation reduction per point of increased unemplo#ment in the foreign countr#.

Apper left1hand side cell' Apper right1hand side cell' %ower left1hand side cell' %ower right1hand side cell'

XM N 8 XN8 XM N > XN8 XMN 3 XN> XM N 2 XN2 Coreign Ker# &estrictive

Coreign I 0omewhat &estrictive Gome I 0omewhat &estrictive Gome I Ker# &estrictive

Answer' /n this case7 the two countries will use the Esomewhat restrictiveF policies.

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