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ECON2020 Tutorial 7

Semester 1 2023

1 Short Answer Questions

1. In Lecture 7, it was observed that fiscal policy is ineffective with for a small open economy with a pure floating exchange rate regime. Let us complete the analysis here.

Suppose the economy (including the foreign exchange market) is initially in equilibrium. The exchange rate regime is pure floating.

Next suppose the government attempts to stimulate output by engaging in expansionary fiscal policy by increasing government purchases (∆ > 0).

(a) How will the increase in government purchases affect the IS curve? Use the Keynesian Cross model to explain your answer.

(b) Using an appropriate IS-LM diagram, explain the immediate impact of the shift of the IS curve on domestic interest rate and net capital flows. (Hint: you should be paying attention to the point of intersection between the new IS-curve and the LM curve.)

(c) Given your answer to part (b), will the domestic currency appreciate or depreciate in nominal terms? Illustrate your answer with an appropriate diagram for the foreign exchange market.

(d) Given your answer to part (c), will the domestic currency appreciate or depreciate in real terms? Briefly explain your answer. (Hint: the IS-LM model is a short-run model.)

(e) Given your answer to part (d), what is the impact of the expansionary fiscal policy on the

country’s net exports? How would this change in the country’s net exports affect the IS curve? Illustrate your answer with an appropriate Keynesian Cross diagram.

(f) Given your answers to the above, what is the overall impact of the government’s expansionary

fiscal policy on output in the IS-LM model? (Hint: At what point would the IS curve stop shifting?)

2. In this question we’ll analyse the impact of an increase in net tax ( ) in a small open economy with a fixed exchange rate regime, and compare it to the impact of an equivalent increase in net tax on a closed economy. For the questions below, assume that both economies start off with the same IS-LM equilibrium interest rate and income (i0(*),Y0* ), and that i0(*) = if (i.e. that the domestic interest rate initially equals the foreign interest rate).

(a) Use the IS-LM model to analyse the overall impact of the increase in net tax (∆ > 0) on equilibrium output for a closed economy. (Note: Our IS-LM analysis for Topics 3 to 6 have been for closed economies.) Illustrate your answer with an appropriate IS-LM diagram.

(b) Use the IS-LM model to analyse the overall impact of an identical increase in net tax on equilibrium output for a small open economy with a fixed exchange rate. Illustrate your answer with an appropriate IS-LM diagram. (Take into consideration any changes to interest rates, exchange rates and money supply when considering the overall impact to the IS-LM equilibrium.)

i. closed economy

ii. small open economy.

Illustrate your answer with an appropriate diagram.

3. In this question, we will consider the impact of a change in demand for a country’s exports - such that at the same real exchange rate R and foreign income Yf , the quantity of exports demanded increases from X0 (Yf, R) to X1 (Yf ,R), with

X1 (Yf ,R) > X0 (Yf ,R).

An example of this scenario will be the ongoing Russian invasion of Ukraine. Before the invasion on 24 February 2022, Ukraine was the world’s sixth largest wheat producer. The invasion and subsequent Russian blockades of Ukrainian Black Sea ports drastically limited grain exports from Ukraine. Grain importers have to turn towards alternative grain exporters, such as Australia,

resulting in a significant increase in Australian grain exports in Q2 2022 (at least compared to historical trends).

Australia’s energy exports were similarly impacted. Russia is one of the world’s largest energy producers, but economic sanctions imposed on Russian energy exports have diverted energy demand towards other suppliers. Consequently, Australian exports of coal and other mineral fuels increased in Q2 2022.

Suppose the Russian invasion of Ukraine has increased demand for Australian exports. For this question, assume that Australia is a small open economy.

(a) What impact would this have on Australian net exports?

(b) Given your answer to (a), what impact would the war have on the IS curve for the Australian

economy? Briefly explain your answer.

(c) Given your answer to part (c), use the IS-LM model to analyse the immediate impact of the increased export demand on the Australian economy. What is the immediate impact on domestic interest rate (i) and output (Y)? (I.e. before the economy returns to the overall IS-LM equilibrium on the BP schedule.)

(d) How would you expect the nominal and real exchange rate to change, given your answer to part (c)? What subsequent impact would this have on net exports (after the initial increase due to increased demand for Australian exports)?

(e) What is the overall impact of the initial increase in export demand on the Australian economy?

Use the IS-LM model to explain the overall effects on output, net exports and domestic interest rate.

4. (Not examinable) In Lecture 7, we discussed why fixed exchange rate regimes might be appropriate for small open economies like Singapore. In particular, one conclusion from Lecture 7 is that mon- etary policy conducted in the form of changes in nominal money supply is ineffective at influencing economic output in a small open economy.

One implication of this discussion is that the choice of an exchange rate target might be an appro- priate monetary policy tool for a small open economy (just as a choice of a target interest rate (cash rate) or money supply might be an appropriate monetary policy tool for a large open economy like the US or Australia).

In other words, it might be more effective for small open economies like to Singapore to adopt a fixed exchange regime (kind of... Singapore’s monetary policy is implemented by changes to the trend and width of the band of the Singapore Dollar exchange rate relative to a basket of the currencies of its major trading partners - see this link for a more precise discussion of Singapore’s monetary policy framework), and to implement monetary policy by changing its target exchange rate.

In this question, we’ll examine economic effect of currency revaluation (changes of the target ex- change rate) on a small open economy like that of Singapore’s.

Suppose the Singaporean economy is currently in equilibrium - such that the current economy is at the intersection of the IS curve, LM curve and the Balance of Payments schedule, and that the current nominal exchange rate is at the Monetary Authority of Singapore’s (MAS) target exchange rate (e = ).

One reason why exchange rate targeting might be more effective for a small open economy is that fact that due to free capital flows, a small open economy might not have effective control over domestic money supply (please refer to Lecture 7 Slides 70 to 72 for a discussion on this phenomenon). So let’s assume that any changes in target exchange rate has an insignificant impact on domestic money supply (for simplicity).

Suppose the MAS lowers the target exchange rate from 0 to 1 .