When interest rates rise in the United States, global financial flows are attracted to US-based assets, at the expense of “emerging market” economies.
ECO 320L quiz four key March 2017
When interest rates rise in the United States, global financial flows are attracted to US-based assets, at the expense of “emerging market” economies. If policymakers in an emerging economy take no action, the increase in the foreign (i.e., US) nominal interest rate causes the nominal exchange rate to decline. In a “textbook” economy, the nominal depreciation would cause aggregate demand to increase; both exports and import-substitutes will increase. A distinctive feature of emerging economies, however, is that the reduced attractiveness of their assets (relative to foreign assets) makes it harder for businesses to finance their investments, and the decrease in investment overwhelms the change in net exports, so aggregate demand declines.
The aggregate supply curve and aggregate demand curve
have parameter values: g = 0.8, d = 157, f = 5, and YP = 132.
Assume that when curves shift, the slopes never change. In each year, expected inflation is updated to equal last year’s inflation. Exogenous changes are permanent.
This economy is in long-run equilibrium, when (in year zero), nominal depreciation causes (1) d to decline to 140 and (2) a price shock: r = 0.75 in year one, then returns to zero in year two.
1. Calculate the values of output and inflation in year two. [Note: In year zero, the economy is already away from long-run equilibrium. Round inflation to the nearest hundredth of a percentage point and output to the nearest tenth.]
132 = 157 – 5p Þ p= 5 p0 = 5 + 0.8(140 – 5p0 – 132) = 11.4/5 = 2.28
p1 = (8.68 + 0.75)/5 = 1.886 p2 = 8.286/5 = 1.6572 Þ Y2 = 131.7
2. What is the rate of inflation in the new long-run equilibrium?
132 = 140 – 5p Þ p = 1.6
3. Suppose that monetary policymakers intervene (i.e., change d) in year two so that p2 = 6%. Calculate Y2.
6 = 1.886 + 0.8(d – 30 – 132) Þ d = 167.1425 Þ Y2 = 137.1
4. On a graph of aggregate demand and aggregate supply, show this economy in years one through three, and in the new long-run equilibrium. [Numbers are optional. Label the graph clearly and completely.]
The monetary policy intervention (#3) causes inflation in the long-run equilibrium to be higher than it would otherwise be.
5. Reproduce the table to show how the new long-run equilibrium is affected by the change in monetary policy.
- lower (¯),
- higher (),
- not different (ND), or
- not enough information (??).
e is the real exchange rate = , where P* is the foreign price level.
| C | Ý | E | Ý | pe | Ý |
| I | Ý | r | ß | G | ND |
| EX | ß | p | Ý | Y | ND |
| IM | Ý | i | Ý | e | Ý |
LRE Þ Y is ND
G is exogenous and unmentioned, so ND.
Higher p Þ higher pe.
The monetary intervention is lower r.
Lower r Þ higher C & higher I. But, both Y and G are ND, so NX must be lower Þ higher E Þ higher e (plus, higher p Þ higher e).
The only way E can be higher is if i is higher (the increase in pe > the decrease in r). (Plus, an emerging economy can have high aggregate demand only if its currency is strong enough to attract global savings.)
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