1.Last week the European Central Bank moved interest rates further into negative territory. As reported in Barron's Magazine, the ECB "said it will lower the rate the ECB vharged banks to 10 basis point (0.1 percentage point), to minus 40 basis points...The ECB would provide banks with long-term cash, free of charge but with a twist: The central Bank would pay the banks 40 basis points if they actually made loans with the money...In addition, the ECB also upped its monthy bond purchases to 870 billion euros...And the central bank will start buying corporate bonds from European nonfinancial corporations with investment-grade credit ratings."
The following questions ask you to compare the short- and long-run effects of these policies, which are all designed to raise the money supply and lower interest rates.
(a) The same Barron's article observes that "the euro plunged" after the ECB announcement. In an FX diagram, show that our short-run model (Chapter 4) predicts this outcome. Your vertical axis should measure the euro/dollar exchange rate.
(b) According to the analysis of overshooting in Chapter 4, a one-time rise in the money supply eventually leads to a higher price level (P in the Eurozone), while the interest rate R returns to its long-run level. State the real interest parity condition, and explain why it predicts that the one-time rise in the money supply will not change the long-run nominal interest rate in the home country (Europe). Assume that the Eurozone's real exchange rate is constant across time. (Recall that the long-run equilibrium real exchange rate is determined by the output market, not monetary policy.)
(c) Suppose that instead of a one-time rise in the money supply, the ECB increases the rate of growth in the money supply, and that it continues to maintain this higher rate of growth for a considerable period of time. What does this higher growth rate imply about inflation in the Eurozone? Explain, using our long-run model of the exchange rate (Chapter 5). How does this higher growth rate affect the nominal interest rate changes in the Eurozone. Explain, using our real interest parity condition. (Again assume a constant real exchange rate.)
(d) Under our assumption of a fixed real exchange rate, how does the increase in money supply growth affect the nominal euro/dollar exchange rate in the long run? What condition are you using? Are you describing an appreciation or depreciation in the euro? Are you describing the level of the exchange rate or the rate of change in the exchange rate?
2. In class, we analyzed changes in the money supply, taxes, and government spending. Suppose instead there is a temporary increase in investment demand, such as the one that occurred in the U.S. during the 1990's and 2000. Use the DD-AA model to answer the following questions.
(a) For a given real exchange rate, use the goods-market diagram (the one with an aggregate demand curve) to show how the change in investment changes the equilibrium Y. (As explained in class the nominal exchange rate is a fixed proportion of the real exchange rate in the short-run, since price levels do not change.)
(b) Using your answer for (a), show how the DD curve shifts.
(c) How does the AA curve shift? Explain.
(d) Using your answers to (b) and (c), show in a DD-AA diagram how equilibrium output Y and the exchange rate E change.
3. The Presidential candidate, Bernie Sanders, has proposed large increases in both taxes and government expenditures. He claims that his proposals will not increase the government budget deficit, because the increases in expenditures will be paid for by the increases in taxes. In terms of the notation from class and the text, government spending, G, will increase by the same amount as taxes, T, will increase. Does this mean that Sanders' policies will not increase employment and output? Answer this question in the following steps.
(a) For a given real exchange rate, use a goods-market diagram to show how temporary identical increases in G and T change Y. (Hint: What do we know about the marginal propensity to consume out of disposable income, Y - T?)
(b) Using your answer for (a), show how the DD curve shifts.
(c) How does the AA curve shift? Explain.
(d) Using your answers to (b) and (c), show in a DD-AA diagram how the identical increases in G and T affect output Y in the short-run. Also show how the exchange rate E changes.
4. A new government is elected and announces that once it is inaugurated, it will increase the money supply. What is the economy's response to this announcement? Answer this question in the following steps.
(a) Use our foreign-exchange-market and money-market diagrams (the ones that share the same horizontal axis) to show how the increase in thefuture money supply will affect the future exchange rate. (Hold output Y fixed for both (a) and (b).)
(b) Your answer to (a) tells you how the future increase in the money supply affects the current expectation of the future exchange rate (the "expected future exchange rate," Ee). Use another set of foreign-exchange-market and money-market diagrams to show how this change in expectations affects the current exchange rate. Note: There is no change in the current interest rate. (Recall a similar question on a previous problem set.)
(c) Using your answer to (b), show how the AA curve shifts. Is there any shift in the DD curve? Explain.
(d) Using your DD-AA diagram, show how the new government's announcement affects current output Y and the exchange rate E.