EC1002 Macroeconomics

4: Exchange rates and the open economy

1. Suppose Greece has to borrow extensively from foreign countries, thereby acquiring
substantial foreign debt. Show graphically what has to happen to its equilibrium real
exchange rate. Why is this change required? If Greece remains within the Eurozone,
how can such a change be accomplished?

2. In an open economy with a fixed exchange rate and perfect capital mobility, a mortgage
crisis leads to a fall in consumer spending
a. How does the economy come back to internal and external balance if the
government does not intervene? Explain the process in words and illustrate
graphically.
b. What would be the impact of an expansionary monetary policy? Explain in words
and illustrate graphically.
c. What would be the impact of an expansionary fiscal policy? Explain in words and
illustrate graphically.
d. Now assume the exchange rate is flexible, what would be the most effective macro
policy for the government to employ? Explain in words and illustrate graphically.

3. Exam-Style Question: Answer the following questions about exchange rate regimes:
a. [6 marks] Explain the difference between a fixed exchange rate regime and a floating
ex- change rate regime. What policy actions does a country have to follow to
maintain a fixed exchange rate? What is a dirty float?
b. [8 marks] The UK has a floating exchange rate and capital mobility. The exchange
rate between the US dollar and the UK pound changed from $1.48 dollars per pound
on June 23rd, 2016 to $1.36 dollars per pound on June 24th, 2016 following the vote
to leave the European Union.
i. Did the UK pound appreciate or depreciate relative to the US dollar?
ii. Did the change in the exchange rate make it more or less expensive for UK
residents to buy goods manufactured in the US?
iii. Does the change in the exchange rate make exporting to the US more or less
attractive for UK based firms?
iv. What effect is the change in the exchange rate likely to have on inflation in
the UK?
c. [8 marks] Consider an open economy with a fixed exchange rate and perfect capital
mobility. Assume that it is impossible to devalue the currency. Suppose that inflation
increases. Can the central bank change the interest rate in order to reduce inflation?
Is fiscal policy effective in this situation?
d. [8 marks] Consider an open economy with a floating exchange rate and perfect
capital mobility. Suppose that inflation increases. Can the central bank change the
interest rate in order to reduce inflation? Is fiscal policy effective in this situation?