EC3343 Tutorial 7 Suggested Solutions

Q1. Consider a country with a flexible exchange rate regime. Assume that the
economy is initially at full employment. Suppose the government imposes a tariff on
all imports. Use the DD-AA model to analyse the short run effects of a temporary tariff.
Illustrate with graphs and explain.
Answer: A tariff is a tax on the consumption of imports. Hence, with a tariff, imports
will decrease and the aggregate demand will increase for any level of the exchange
rate. This is depicted by a rightward shift of DD curve. If the tariff is temporary, output
will rise, the exchange rate appreciates, and there is no change in expected exchange
rate. The higher output will raise real money demand, which leads to a higher interest
rate. There is no shift in the AA curve.

Q2. Assume an economy is initially at full employment. Using the DD-AA model,
analyse the output and current account effects of a temporary import tariff under a
fixed exchange rate regime in the short run. Show with graphs and explain. What
would happen if all countries in the world simultaneously raise import tariffs?
Answer: An import tariff raises the price of imports. Domestic consumers shift
consumption from imports to domestically produced goods. This causes an outward
shift in the DD curve, increasing output and appreciating the currency. In order to
maintain the fixed exchange rate, the central bank must increase the money supply,
an action depicted in the diagram as an outward shift in the AA schedule.
Correspondingly, both output and current account balance increase.

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A fall in imports for one country implies a fall in exports for another country, and a
corresponding inward shift of exporting country’s DD curve, necessitating a monetary
contraction by the central bank to preserve its fixed exchange rate. If all countries
impose import tariffs, then no country succeeds in turning world demand in its favour
or in raising exports. Trade volumes shrink, however, and all countries lose some of
the gains from trade.

Q3. Suppose a foreign country has a flexible exchange rate regime and the domestic
country has a fixed exchange rate regime. In both countries, there is free capital
mobility. Suppose the central bank in the foreign country has implemented one round
of bond purchase in their money market. Explain the effects in the foreign country and
show how the domestic country will respond.

Answer: The bond purchase program in foreign country will raise money supply in
foreign country, which reduces the foreign interest rate and depreciates the foreign
currency. Relatively, the domestic currency will appreciate against the foreign currency.
Since the domestic country has a fixed exchange rate regime, to keep the exchange
rate constant, the central bank of domestic country will have to increase money supply
to match the reduction in domestic interest rate and depreciate domestic currency.

Q4. Suppose a foreign country has a fixed exchange rate regime and the domestic
country has a flexible exchange rate regime. In both countries, there is free capital
mobility. Suppose the foreign country has implemented fiscal expansion. Explain the
effects in the foreign country and show how the domestic country will respond.
Answer: If the foreign country implements a fiscal expansion, DD curve in the foreign
country will shift to the right, leading up to an increase in output and currency
appreciation. (Note that appreciation will be larger under permanent fiscal expansion
because of change in expectation.) However, foreign country is a fixed exchange rate
regime. To keep the exchange rate constant, foreign central bank needs to raise
money supply to depreciate their currency. In the end, there will be no change in the
exchange rate. Domestic country does not need to respond because it has a flexible
exchange rate regime.

Q5. The 2008 Global Financial Crisis has brought negative output shocks in countries
around the globe. Consider the case of Ireland and Iceland. Explain graphically why
the different exchange rate systems in the two countries can make a difference to their
recovery paths.
Answer: Iceland has a flexible exchange rate regime. With the 2008 global financial
crisis (GFC), the negative shock in output in Iceland reduced the real money demand
and depreciated the Icelandic króna (ISK). The currency depreciation then granted
Iceland an advantage in exporting industries, raising their exports and reducing their
imports, thus facilitating the recovery of Iceland’s output.

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Ireland, in essence, has a fixed exchange rate regime, as part of the euro area. With
the 2008 GFC, Ireland also experienced a negative output shock and DD shifted left.
However, being “pegged” to the Euro, to keep the exchange rate and interest rate
constant, AA curve shifted to the left, along with leftward shift in the real money
demand and a contraction in the real money supply within Ireland. The shift in the AA
curve further reduced the output (compared to the case of a flexible exchange rate
regime) and prevented the functioning of exchange rate as an automatic stabilizer.

Q6. The People’s Bank of China (PBoC) is confronted with a permanent current
account and capital account surpluses from 2000 to 2010. To control the money supply
and prevent inflation, it uses two tools to sterilize the foreign currency inflows:
(i) The variation of Required Reserve Ratio (which obliges the banks to make
a deposit to the Central Bank where the amount of the deposit corresponds
to a percentage of the credits they grant), and
(ii) The selling of “Central Bank Bills”.
Elaborate and explain the pros and cons of each type of intervention.
Biblography

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Ma, Guonan, Yan Xiandong, and Liu Xi. "China’s evolving reserve
requirements." Journal of Chinese Economic and Business Studies 11, no. 2 (2013):
117-137. https://www.bis.org/publ/work360.pdf

RRR (Hikes) Bank Bills (Selling)

Nature of instrument A structural Instrument. A short term Instrument.
The Central Bank could Can be reversed easily.
not change the RRR too
often.
Cost of using this Central Bank may fix the The interest rate for Bills
instrument remuneration of the RRR depends more on the
deposits. market conditions.
Impact on the interest rate RRR affect the running To sell more Bills the
cost of banks and thus Central Bank has to
the lending rates to firms accept a rise in their
and households. yields.
Effect on foreign RRR has no effect in this. Selling Bank Bills
exchange risk premium increases the stock of
on Bank Bills RMB assets held by the
denominated in RMB private sector and thus
the risk premium on these
assets.