Question

6. Answer the following questions and take into consideration the following assumptions: (1) Germany is a large open economy that has influence on the world market for loanable funds. (2) Turkey is a small open economy with an exchange rate e - euro/lira. a. Germany is concerned about Turkey's depreciating lira. Should Germany pursue an expansionary or a contractionary fiscal policy to reverse the depreciation of the lira (want e↑)? Explain how the fiscal policy affects the world market for b. Would the change in r* create a net capital inflow (NCI) or a net capital outflow (NCO) for Turkey, a SOE which trades heavily with Germany? Use the capital flow equation below to explain. [5 points] CF Amount Turkey lends abroad-Amount Germany lends to Turkey c. How would the NCI or NCO appreciate the euro/lira flexible exchange rate? Explain by determining the changes in the demand and the supply of lira in the foreign exchange market. No graph is needed. [5 points d. If Germany were not to intervene (r* kept constant), what fiscal policy should Turkey implement at home to create an appreciation of the euro/lira exchange rate? Explain the increase in the exchange rate. No graph is needed. [10 points]

Answer 1

Solution

a.Yes Germany should pursue an expansionary fiscal policy to reverse the depreciation of Lira.

When Germany goes for an expansionary fiscal policy ( A fiscal policy which results in the increase in aggregate demand /or GDP in an economy),the money supply in the economy is increased by the Central Bank of Germany by usage of tools like cutting taxes and spending more on the people.So,the availability of money with the people / economy increases.

So,this results in inflation . By definition,inflation is the general price rise of all the goods and services in an economy ; meaning the value of the money decreases so the currency of Germany (Here the currency of world also) will depreciate in relation to Lira.

In this manner in order to reverse the depreciation of Lira,the world currency itself is allowed to depreciate .

So, this expansionary policy leads to increase in the loanable funds.It also leads to higher interest rates mainly because the govt.is increasing it's spending by borrowing more money from the market.

b.So,the world interest rate r^*will increase so there will be NET CAPITAL OUTFLOW for Turkey as the funders in Turkey will be thinking to lend to the world due to the higher interest rates that they can fetch on their investments.

c.So NCO (Net capital outflow) of Turkey is there.It means more money is getting converted from Lira to Euro when compared to from Euro to Lira.

So,there is greater demand for Euro,so the currency of the world / Germany will appreciate.

d.If Germany does not intervene :

Turkey will opt for a contractionary fiscal policy by increasing the interest rates in the economy.The money supply in the economy will reduce as now the people tend to save and invest more of their money due to the high interest rates that are being offered.So the inflation reduces resulting in the increase in the value of the currency which means the Lira strengthens / appreciates with respect to Euro

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