Problem Set 8 Solutions

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Department of Economics University of California, Berkeley

Fall 2012 Econ 182

Solutions Problem Set 8
Problem 1. Exchange Rates and International Transmission a. Suppose that the US engages in a monetary expansion. Since exchange rate is pegged to the US dollar, country X’s monetary authorities are forced to expand their money supply as well (recall that i = i* under FixER). Interest rates fall in country X, output expands, and of course the exchange rate remains unchanged. On the AA-DD diagram, both the AA and the DD schedules shift to the right. The shift in DD can be explained by the increase in US output which causes an increase in net exports of country X. In addition, smaller interest rates are known to increase investment, which can also explain the shift in DD. The case of monetary contraction is similar. Thus with fixed exchange rates, monetary shocks transmit positively from the US to country X.

b. Suppose now that the US aggregate demand increases. Perhaps fiscal policy in the US expands. An increase in the US aggregate demand increases US nominal rates and, with fixed exchange rates, forces monetary authorities in country X to contract the money supply (in order to keep i = i*). Monetary contraction in country X leads to a fall in output due to a decline in investment. Exchange rate of course is unchanged. In the AA-DD diagram, both AA and DD schedules shift to the left. The reverse argument applies to negative US aggregate demand shocks. Thus when shocks originate in US aggregate demand, they transmit negatively from the US to country X.

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Department of Economics University of California, Berkeley

Fall 2012 Econ 182

c. With flexible exchange rates, US monetary expansion results in a decline in US interest rates and a depreciation of the dollar, and therefore appreciation of the country X’s currency. The appreciation of country X’s currency leads its output to contract (decline in net exports). Interest rates in country X will...
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