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(c) Use appropriate diagram, explain the exchange rate overshooting hypothesis. [8 marks]

In its initial depreciation after a money supply rise, the exchange rate jumps from E 1 up$/€ to E 2 , a depreciation greater than its long-run depreciation from E 1 to E 3. The exchange rate is said to overshoot when its immediate response to a disturbance is greater than its long-run response. Exchange rate overshooting is an important phenomenon because it helps explain why exchange rates move so sharply from day to day. The economic explanation of overshooting comes from the interest parity condition.

Question 4
(a) Using the AA/DD framework, explain the separate effects of a temporary monetary expansion and a temporary fiscal expansion on the exchange rate, output and the current account. [10 marks]

Effects of a Temporary Increase in the Money Supply

An increased money supply shifts AA1 upward to AA2 but does not affect the position of DD. The upward shift of the asset market equilibrium schedule moves the economy from point 1, with exchange rate E 1 and output Y 1, to point 2, with exchange rate E 2 and output Y 2. An increase in the money supply causes a depreciation of the domestic currency, an expansion of output, and therefore an increase in employment.

At the initial output level Y 1 and given the fixed price level, an increase in money supply must push down the home interest rate, R. We have been assuming that the monetary change is temporary and does not affect the expected future exchange rate, E e, so to preserve interest parity in the face of a decline in R (given that the foreign interest rate, R*, does not change), the exchange rate must depreciate immediately to create the expectation that the home currency will appreciate in the future at a faster rate than was expected before R fell. The immediate depreciation of the domestic currency, however, makes home products cheaper relative to foreign products. There is therefore an increase in aggregate demand, which must be matched by an increase in output.

Effects of a Temporary Fiscal Expansion

Initially the economy is at point 1, with an exchange rate E 1 and output Y 1. Suppose the government decides to spend $15 billion to develop a new space shuttle. This one-time increase in government purchases moves the economy to point 2, causing the currency to appreciate to E 2 and output to expand to Y 2. The economy would respond in a similar way to a temporary cut in taxes. The increase in output caused by the increase in government spending raises the transactions demand for real money holdings. Given the fixed price level, this increase in money demand pushes the interest rate, R, upward. Because the expected future exchange rate, E e, and the foreign interest rate, R*, have not changed, the domestic currency must appreciate to create the expectation of a subsequent depreciation just large enough to offset the higher international interest rate difference in favor of domestic currency deposits.

How Macroeconomic Policies Affect the Current Account

The current account effects of macroeconomic policies can now be examined. As shown earlier, an increase in the money supply, for example, shifts the economy to a position like point 2, expanding output and depreciating the currency. Since point 2 lies above XX, the current account has improved as a result of the policy action. Monetary expansion causes the current account balance to increase in the short run. Consider next a temporary fiscal expansion. This action shifts DD to the right and moves the economy to point 3 in the figure. Because the currency appreciates and income rises, there is deterioration in the current account.

(b) How would these effects differ if the expansionary policies in (a) were permanent rather than temporary?

A Permanent Increase in the Money Supply

A permanent increase in Ms must ultimately lead to a proportional rise in E. Therefore, the permanent...
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