Answers to Questions in Chapter 24



Answers to Questions in Chapter 23

Note: No. before ( indicates a page number

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537 ( Imagine that there is an inflationary gap, but a balance of payments equilibrium. Describe what will happen if the government raises interest rates in order to close the inflationary gap. Assume first that there is a fixed exchange rate and then that there is a floating exchange rate.

Fixed exchange rate: The higher interest rates will reduce aggregate demand and thus help to close the inflationary gap. The higher interest rates, however, will lead to an increase in the demand for and a decrease in the supply of dollars: the capital account will move into surplus, and external balance will be destroyed. The reduction in inflation will also have the effect of increasing exports and reducing imports, thereby also improving the current account.

Floating exchange rates: As under a fixed exchange rate, the higher interest rates will reduce aggregate demand and thus help to close the inflationary gap. The higher interest rates will lead to an increase in the demand for and a decrease in the supply of dollars: the capital account will move into surplus, and external balance will be destroyed. The exchange rate will thus appreciate, thereby restoring external balance. The effect of the appreciation will be also to reduce the demand for exports (an injection) and increase the demand for imports (a withdrawal). This will help to reinforce the effect of higher interest rates in dampening aggregate demand and restoring internal equilibrium.

From the above it can be seen that monetary policy has a bigger effect on the domestic economy under floating than under fixed exchange rates.

537 ( What adverse internal effects may follow from (a) a depreciation of the exchange rate; (b) an appreciation of the exchange rate?

(a) It may fuel inflation by increasing the price of imported goods and reducing the need for export industries to restrain cost increases.

(b) It may damage export industries and domestic import-competing industries, which would now find it more difficult remain competitive.

538 ( Under what circumstances would (a) deflationary and (b) reflationary policies cause no conflict between internal and external objectives?

(a) When there was an inflationary gap and a balance of payments deficit.

(b) When there was a deflationary gap and a balance of payments surplus.

540 ( How would raising interest rates in this way affect the balance between the current and capital accounts of the balance of payments?

It will have a bigger effect on the capital account. Thus if the capital account had been in deficit (caused by the `large scale selling of dollars’), it will move back towards balance. The current account will tend to deteriorate, however, as a result of the higher exchange rate, although this will be to some extent offset by the reduction in aggregate demand (and hence demand for imports) caused by the higher interest rates.

541 ( (Box 23.1) Why do you think the Reserve Bank was concerned by the fall in the exchange rate?

The Reserve Bank has a policy objective to keep inflation in the range of 2-3% (see Chapter 19). The substantial fall in the exchange rate will have led to a rise of a similar magnitude in the Australian dollar price of imports. This in turn will have increased the price level increasing the rate of inflation, and threatening the achievement of the inflation target.

543 ( (Box 23.2) 1. Suppose that under a dirty floating system the government is worried about high inflation and wants to keep the exchange rate up in order to prevent import prices rising. To tackle the problem of inflation it raises interest rates. (Similar policies have been pursued in recent years.) What will happen to the current and capital accounts of the balance of payments?

The high interest rates will cause a surplus on the capital account. The higher exchange rate will cause a deficit on the current account.

544 ( Why will excessive international liquidity lead to international inflation?

Because countries can use the extra reserves to finance the purchase of extra imports. The extra liquidity is thus equivalent of an increase in `world money supply'. If this grows faster than world trade, then there will be a problem of excess demand and demand-pull inflation.

545 ( To what extent do Keynesians and new classicists agree about the role of fixed exchange rates?

They are both critical, as pages 543-5 make clear. They both argue that monetary policy is relatively ineffective under fixed exchange rates, and that overall imbalance on the balance of payments may persist.

545 ( If this is the case, should firms worry about losing competitiveness in world markets if domestic inflation is higher than world inflation?

Yes, because (in the example given) the demand for Australian goods in Japan will fall. They will be less competitive with Japanese produced goods and with Japanese imports from other countries.

546 ( Will there be any cost to the Australian economy from a decline in the demand for exports resulting from a world recession?

Yes. The depreciation in the exchange rate will reduce the demand for imports (unless the world recession causes the foreign currency price of imports to fall by the same percentage that the exchange rate depreciates). A reduction in imports will mean that the exchange rate does not have to fall so far and thus the level of exports will not be fully maintained. There is thus a cost to the export sector. This effect will be partly or even wholly offset, however, by the boost to aggregate demand (and hence a further reduction in the exchange rate) caused by the fall in imports (a withdrawal).

548 ( (Box 23.4) 1. If the Malaysian ringgit is undervalued by 53% in PPP terms against the US dollar, and the Swiss franc overvalued by 39%, what implications does this have for the interpretation of Malaysian, Swiss and US GDP statistics?

The GDP figures understate the purchasing value of Malaysian national income by 53% relative to US national income, and overstate the purchasing value of Swiss national income by 39% relative to US national income. In other words, at the exchange rates in question, Malaysian national income seems 53% lower relative US national income than it really is in purchasing terms, and Swiss national income seems 39% higher relative to US national income than it really is in purchasing terms.

549 ( Why would banks not be prepared to offer a forward exchange rate to a firm for, say, five years' time?

It would involve too much risk. The longer the time period the greater the scope for movements in the exchange rate and the more unpredictable they become.

550 ( (Box 23.5) Why do high international capital mobility and an absence of exchange controls severely limit a country's ability to choose its interest rate?

Because if its interest rate were lower than international rates, there would be a massive outflow of capital if international capital were highly mobile and there were an absence of exchange controls. The resulting fall in the money supply would push the interest rate up to the international level. Similarly if its interest rate were higher than international rates, the resulting massive inflow of capital would increase the money supply and drive its interest rate down to the international level. These effects are stronger if the country is attempting to peg its exchange rate.

551 ( What could be done to stop the exchange rate appreciating?

▪ Central bank sales of the domestic currency on the foreign exchange market, thereby building up reserves.

▪ Reducing interest rates.

▪ Removing exchange controls.

▪ Reflationary fiscal and monetary policy.

554 ( 1. Why did the ‘contagion’ spread to countries outside South-East Asia?

For several reasons: (a) The events made leaders of capital more risk averse and firms throughout the world find ti more difficult to borrow overseas; (b) It caused speculative pressure on other currencies; (c) It reduced the level of exports to South-East Asian countries.

554 ( (Box 23.6) What policy measures could the South-East Asian countries have adopted before the crisis to prevent it occuring?

551 ( What could be done to stop the exchange rate appreciating?

They could have adopted floating exchange rates and hence prevented the over valuation of their currencies. They could have supervised back lending and imposed prudential rules.

556 ( Assume that the United States economy expands. What wil determine the size of the multiplier?

The size of the initial import of the growth in a country’s exports to the USA will depend upon (a) how open the economy is, (b) the proportion of the exports that go to the USA. This impact is thus multiplied by the mornal multiplier, whose magnitude depends on the marginal propensities to consume and import and on tax rates (see Appendix to Chapter 17).

557 ( Are exports likely to continue growing faster than GDP indefinitely? What will determine the outcome?

There is no reason why they should not grow faster than GDP – after all they have done so for the last half century. By definition imports grow at the same rate and this trade reflects the advantage of specialisation and the desire of consumers to have a wide choice of products. The rate of growth of exports will depend largely on how successful policies are to further liberalise trade.

558 ( Give some examples of beggar-my-neighbour policies.

Tariffs, quotas, export subsidies, ‘buy Australian’ schemes.

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