Macroeconomic Policy I
ECON3236 International Finance
Girish Bahal
Main reading: Krugman, Obstfeld, and Melitz, Ch 17 pages 504-508
(Output and the Exchange Rate in the Short Run)
Learning Objectives
Understand ...
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The impact of a temporary change in monetary policy on the short-run
equilibrium
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The impact of a temporary change in fiscal policy on the short-run
equilibrium
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The optimal policy response to temporary disturbances
Recall: The short run equilibrium
Important questions:
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How do E and Y change in
response to temporary changes in:
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Monetary policy?
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Fiscal policy?
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How to respond to temporary
disturbances in the economy?
Temporary policy changes
Temporary policy changes are expected to be reversed in the near future
Examples:
(cid:73) A temporary ↑ in Ms which is reversed in the future
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A temporary ↑ in G
Temporary policy changes do not affect expectations about exchange rates in
the long-run
A temporary change in monetary policy
A temporary ↑ in the money supply ↑
Ms shifts the AA curve up
(cid:73) At Y1 and fixed P, Ms ↑ → R ↓
(money market)
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Domestic currency depreciates
immediately (FX market)
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Aggregate demand ↑ → Y ↑
A temporary change in monetary policy
Note: An ↑ in Ms has no effect on the
DD schedule
Hence, a temporary expansionary policy
causes:
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thedomesticcurrencytodepreciate
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output to ↑ in the short run
Temporary change in fiscal policy
A temporary ↑ in G shifts the DD
schedule to the right
A temporary policy doesn’t affect Ee
→ no effect on the AA schedule
Higher output ↑ the transactions
demand for money → R ↑
→ domestic currency appreciates
against the foreign currency
Temporary change in fiscal policy
New equilibrium is at point 2:
Output increases from Y1 to Y2
Domestic currency appreciates w.r.t.
the foreign currency from E1 to E2
Opposite is true if the govt. pursues a
temporary contractionary fiscal policy
Response to a temporary fall in demand
A temporary fall in demand shifts DD1
to DD2
Output ↓ from Yf to Y2
Domestic currency depreciates from E1
to E2
Short-run equilibrium moves from point
1 to point 2
Response to a temporary fall in demand
Option 1: Temporary fiscal expansion
(cid:73) Restores Yf by shifting DD back
to DD1
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EX rate is restored to its previous
value E1
Option 2: Temporary monetary
expansion
(cid:73) Restores Yf by shifting AA1 to
AA2 (point 3)
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Cost: domestic currency further
depreciates to E3
Response to a temporary ↑ in money demand
A temporary ↑ in money demand shifts
AA1 to AA2
R ↑ → domestic currency to appreciates
from E1 to E2 (point 2)
Demand for net exports ↓ → output
contracts from Yf to Y2
Response to a temporary ↑ in money demand
Option 1: Temporary monetary
expansion
(cid:73) Restores Yf by shifting AA2 back
to AA1 (point 1)
(cid:73) E is back at its previous value E1
Option 2: Temporary fiscal expansion
(cid:73) Restores Yf by shifting DD to
DD2 (point 3)
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Cost: domestic currency further
appreciates to E3
