Question

Question 5: [15 marks A. In an open economy that is on a fixed exchange rate, show the short run effects on output and interest rate of a decrease in consumer confidence. To answer this question, draw the following four diagrams: 3 1. The goods market, 2. The money market, 3. The IS-LM curves, and 4. The interest parity condition. Clearly label the initial and new equilibrium points in each diagram. Provide brief explanations for the changes.

Answer 1

Tose I. i FIXED Exchange rate I Perfect capital mobility Increase in money apply The P ir money supply shifte cm to the right Ecoy goes from A to B. At B, there are Influite capital outflows as domestic livestors seek to purchase higher relishing foulign assets. These inveltors are exchanging their unwanted to l'Indian rupeel for dollars Central bank has agreed to maintain the fixed exchange rate so lit bugs up unwanted Indian Rupee I & sells dollar Money supply falls LM shifts back to Pnitial position. Monetary polley is ineffective Scanneeth CamScanner

MO сч, ..., Case I fred exchange rate Perfect capital mobility Innere in G. 14: Econd moves from AtoB At Bi Bol susplus To keep ex rate fired, central bauk bugs $t sells INR - Monely suppy t o Yo LM shifte out Eloy moues from B to c. ffocal policy ů extemely effectivel In an Is- um model with fixed exchange rate and perfect capital mobility show that ah a in gout ldpinding will lead to detutoration of trade l balance a iny leads to p in imports NX4 Deterioration a trade beelance Scanned with CamScanner

Case & Theed ex rate mobile capital (BP flatter in money suppy Than LM) LIMO blu. Eloy moves from A to B At B: BOP deficit To maintain exchange rate fixed, central bank buys INR, sells & Money supply Scanneta Sapts hack, Cam Sledovately your Ineffective

Case fired exchange rate Immobile Cap (Bl steeper than (M) | |м Молиерце — leo moves from Alto B. At BI BOP deficit To maintain fired ex date ceutial Bank beys INR A sells $. Money supply falls, lim shifts Back Monetary policy is preffective Yo & Monetary policy Icuitun whither I mobile cu) or is ineffective under flixed ex rate. capital & perfectly mobile (2) or immobile con la Case I fixed ex nate Mobile capital ( Bpi flatter than LM) p ing. In in G- Exy moves A to B At B. Böl: sueplies To maintain fixed ex rate licential bank sells INR & boys &. Money supply as. LM shifes but Ecoy moves from B tol. I fiscal policy w effective in alting to a I the level of domestic output under ficed exchan rate with mobile capital but not as effects as if capital had been perfectly motite. Case vil fred ex rate, Immobile capital (BP steeper than cm) la in G. ning to shifts out from A to B . 1 At B! Bop defilit salto maintain fired ex rate, central bank buys INA e calm Scanner

te 20 DAT: I PAGE NO ...dudusells ist i Money supply falls im chifts back fiscal policy ů effective with Pipmobile capital but not as I effective as of capital had | Scanklen wimabell or perfectly mobile Camscanner 4041

Ly #illoreied Interest Parity Condition (1+) INR Li de . IINR. (1+ix) defn 2 1$= & INR ... et dep ed app: 1$ = @f INK . f (1+*) INR . Spot Rate : The rate at which you can exchange Па школу по forward Rate : The rate at which you can agree today to exchange money in future & domestic enterest rate T e foreign interest rate 4 invertor investor IINR in India, he will gee het b) INR after a period. - 1.Gs Scannick

11$= 2 INR : de TI INR ² I dollars the lle dollars in Us will fetch /e (1+2) & trubbos forward rate is fINR per dollar t he invest that amount in forward mukt, The will get € (1+1*) INR ♡ 4 (L48) > { [li*) she is better off cwesting Tu India y liff (1+i) ~ € (1+2) she is better off investing Tin us. I Suppose (+1) > f (l+**), so arbitengge opfôrleurities fexist Investing in India is better so foreigners I will rush to convert their currency into domestic currency so spot exchange rate will appreciate ce falls). To lock in this game, they Taill have to pull money out of the domestic economy in future ie hull & domestic currency in forwared mkt causing domestic currency to depreciate in faucign market if increases) This causes the rate of return on foreign assets le £utit) to rise (f increase e decrease). This process will continue the lti) = f(itet) Suppose (ItŮ ? Citen Tec Sicanistán ama

Xti 747* e ne very small (can be groued) i 7 *t t-e Invest in India is #tf-e Invest in us. Jis * tife I covered interest rate pariety CIRP. Ti is the percentage return of thwest of in India. Hercentage return of investing in us is not only the but also the gain in currency exchange in percentage terms given by te # - Note: Uncovered Interest Parity Condition CIRP condition gave is the condition b/w spot rate and forward rate s forwaed mkts only exist b/w major currencies. so we derive the another relationship bly stot rate and the expected spot rate 11NR . (1+i) There = 2 INR (defn 2) P Scanneth Camer

e She can convert this money back into INR at the end of the period. Unlike the case of CRP She has no way of locking in forward rate Ishe has to wait and do the transaction in the future at et spot rate that she expects to prevail at that time the well expect to end up with et CI+ P*) INR 14 (1+i) > € (1+(*) Invest in India I ((+1) = el (ltet) Invest in Turkey whes Iti + ļE (1+1) speculation opportunities will auice and not the arbitrage opportunities because et s not known at the time of uut Suppose (l+l)E CI+ix), lnvesting in domestie ecot is betten Foreigners will rush to convert their currency into domestic currency causing domestic Currency to appreciate on the spot market (e falls) they deso pean to take domestic money out of the domestic economy in future. This will leado us to expect that urrency will depreciate in the spot market in future pe increases ru continue tie (l+i) = €5 (+iX 6 lettere | Wire condition e un lahir u less likely to hold than are condition kez it deals with specedation trather they arbitrage ICS Scanned with CamScanner

BPAGE NO w .. . lylfae when = 1*... » 1 from CIRP lit I when f= e iz ittee = it. & In fired ex nate regune {= q* from URP (= ettete When t=e , lzi* . 3 - 4 iz it then domestic currency is expected to depreciate overtime under aganist foreign currency from VIRP, when is it screases then 8* y e 06 positive to hold that UIRE if domestic interest rate rises there will be an immediate appreciation of domestic currency from VIRP, e fatti I when exit this condition will hold when e falls. → La Scanied with