ECON 222 Lecture Notes - Lecture 30: Foreign Exchange Market, Neutrality Of Money, Monetary Policy
ECON 222 Week 11 Lecture 2 002
A SOE with Flexible Exchange Rates
Monetary Expansion:
M increases: MS=M/P increases; r decreases; LM shifts right; e decreases; NX increases.
• F is the SR equilibrium.
• When e is lower, NX increases
because Canadian goods become
more attractive. (New SR equilibrium
at F)
• At F,
so prices increase and
LM shifts left.
• r increases; demand for Canadian
currency increases; e increases; NX
decreases; IS shifts left, returning
equilibrium to point E (LR
equilibrium).
• Real variables are unaffected
(monetary neutrality)
• Note that the monetary neutrality
holds in the long run in the Keynesian
model, while it holds immediately in
the classical model.
Fixed Exchange Rates
• In a fixed exchange rate system, the value of enom is officially set by the government.
o Potential problem: the value of enom set by the government may not be the one
determined by the supply and demand for currency.
Overvalued currency:
Undervalued currency:
What happens when the official exchange rate, enom, is not equal to e*nom?
• The central bank will demand or supply its own currency in the foreign exchange market.
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ECON 222 Full Course Notes
Verified Note
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Document Summary
What happens when the official exchange rate, enom, is not equal to e* nom: the central bank will demand or supply its own currency in the foreign exchange market. 002: not sustainable only okay in the short run. Monetary expansion: nominal money supply increases; m/p increases; r decreases; lm shifts right; e decreases (currency is now overvalued), (cid:3041)(cid:3042)(cid:3040) (cid:3041)(cid:3042)(cid:3040), monetary expansion. Monetary policy is not an effective tool to stabilize the economy. must be reversed: g increases: is shifts right; r increases; e increases (currency now undervalued), solution: monetary expansion (m ) that shifts lm right until r=rfor. In sr, y is higher: lr: > , so p increases. =(cid:3041)(cid:3042)(cid:3040)(cid:4672) (cid:4673); e increases; nx decreases; is shifts left: lr equilibrium at point e. Benefits of a fixed exchange rate system: the exchange rate is stable, may improve monetary discipline since less able to carry out highly expansionary monetary policy.
