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Question from Past Macroeconomics Qualifying Exam (Fall, 2005 - Question one) at George Mason UniversityEdit

Compare and contrast the effectiveness of fiscal policy and monetary policy in moving a large open economy from under-employment to full-employment equilibrium under conditions of (a) fixed exchange rates and (b) flexible exchange rates. Clearly outline, and critically evaluate, the models that you utilize

AnswerEdit

Using the Mundell-Fleming IS-LM analysis we can predict movements in overal GDP with changes in both monetary and fiscal policy. For the purposes of this disscussion it will be assumed that "full-employment" will be defined as reaching some N.A.I.R.U. (Non-accelerating Inflation rate of unemployment), typically in the 5-6.5% range for the U.S. "Under-employment," therefore, will be defined as being below trend, or holding a unemployment rate above 6.5%. In this case the Federal Government, a la Keynes, will seek to intervene and reduce unemployment with the tools at their disposal.

  1. Monetary Expansio Policy, fixed exchange rate:
    With a fixed exchange rate monetary expansion would lead (through a shift of the LM curve to the right) to a decrease in the interest rates and capital outflows, which would put downward pressure on the currency. To return to the fixed exchange rate the monetary authority would have to buy currency, which would reverse the original expansion of the monetary base.
  2. Fiscal Expansion, fixed exchange rate:
    With a fixed exchange rate, expansionary fiscal policy will lead to an outward shift in the IS curve (right). This will lead to upward pressure on the interest rate and capital inflows from abroad, which will drive up the exchange rate. Since the exchange rate is not allowed to move the monetary authority will have to intervene and expand the monetary base, leading to a right shift of the LM curve, which leads to a new equilibrium at a higher level of output.
  3. Monetary Expansion, flexible exchange rate:
    With a flexible exchange rate monetary expansion would lead to a right shift of the LM curve which would lower the interest rate and lead to capital outflows. The exchange rate would adjust to the lower level and the new equilibrium would be characterized by a higher level of aggregate output and a lower interest rate.
  4. Fiscal Expansion, flexible exchange rate:
    With flexible exchange rates the interest rate will rise following the increased fiscal spending leading just as above to an increase in capital inflows from abroad, which drive up the exchange rate. The new equilibrium level is characterized by a higher equilibrium interest rate and exchange rate, and a higher level of output.

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