• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

Does economic theory suggest that monetary and fiscal policy play different roles in causing big exchange rate movements?

Extracts from this document...

Introduction

EC201 Assessment Two Question: Does economic theory suggest that monetary and fiscal policy play different roles in causing big exchange rate movements? Discuss the extent to which examples of big exchange rate movements in recent history can be attributed to monetary and fiscal policy changes. In 1950s proponents of flexible exchange rates had assumed that flexible exchange rates would move relatively slowly and smoothly. But within a few years of the disintegration of the Bretton Woods arrangements, that assumption had been shown to be misplaced: there were large and sometimes rapid changes in exchange rates. Are there any suggestive theories behind the observed large fluctuations? The aim of this essay is to demonstrate the different roles that monetary and fiscal policy has played in causing big exchange rates movements and the empirical evidence in recent currency experience. The basic Mundell-Fleming model in 1960s is essentially intact as a way of understanding policy effects to exchange rates. The key assumption in this model is perfect capital mobility which indicates a horizontal BP curve. Firstly, let us discuss the fiscal policy under flexible exchange rate. If the government increases expenditures the IS curve shifts to the right in Figure 1. The domestic interest rate increases and as a result financial investors will want to hold domestic bonds. ...read more.

Middle

Thus, for aggregate demand to remain equal to output, a rise in e must be accompanied by a smaller rise in p. The GG curve in Figure 3 represents this and the AA and GG curves interest on the 45 line at the long-run equilibrium levels e and p. Figure 3 P AA GG (p = 0) e e In Figure 4, above the e = 0 schedule the price is above its long-run equilibrium, so the interest rate is above the foreign level and the exchange rate is depreciating. These movements are indicated by the horizontal arrows. To the left of the p = 0 schedule the exchange rate is below the level where aggregate demand equals output, therefore there is excess supply and the price is falling. These movements are indicated by the vertical arrows. The AA schedule then can be seen as the locus of the points at which the left-right and up-down movements combine to bring about a movement towards the full equilibrium. This is the "saddle path", which is the unique stable path along that full equilibrium can be approached in rational expectations models, and it is assumed that the economy 'jumps' on to such a path. Figure 4 AA GG (p = 0) ...read more.

Conclusion

Individuals face a signal extraction problem when observing a monetary shock and they must infer whether the policy change is permanent. Given imperfect information, the only way to do so is to apply a filtering rule which suggests an increased probability that a monetary policy is persistent the longer it lasts. Under this framework, the exchange rate adjusts slowly to a monetary shock as agents only slowly realize that the shock is persistent. Figure 7 Exchange rate overshooting models However, some economists argued that so little of the post-1995 appreciation was explained by the change in monetary policy by using UIP-based methodology and they believed the behaviour of sterling during that time was puzzle. There are also many alternative explanations such as that the real exchange rate was low by historical standards in early 1996; and the German unemployment increased sufficiently relative to UK unemployment which resulted a further appreciation. To sum up, both the Mundell-Fleming model and the Dornbusch model indicate that a contractive monetary policy or an expansionary fiscal policy will lead an appreciation and vice versa. However, the exchange rates only overshoot under monetary policy. The rise of dollars in 1985 was due to the mixture of monetary and fiscal policy, and the appreciation of sterling since 1996 was also due to the tight monetary policy. Therefore, these theories do explain exchange rates fluctuations with relatively strong evidence. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our GCSE Economy & Economics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related GCSE Economy & Economics essays

  1. What might cause an appreciation of a floating exchange rate? Discuss whether an appreciation ...

    It is difficult for government's to offset the power of speculators because their reserves of foreign currencies are very small compared to daily turnover in the market. In 1997 and 1998 speculative attacks on currencies in Asia and seven years ago, the pound was forced out of the European exchange rate mechanism because of speculative selling of the pound.

  2. The Nature of Macroeconomics

    = ?C/Y * MPS (Marginal propensity to save) = ?S/?Y * MPC + MPS = 1 * Consumption function: C = a + bY o C = consumption o a = autonomous consumption when Y = 0 o b = MPC o Y = income * Saving function: S =

  1. An Empirical Investigation into the Causes and Effects of Liquidity in Emerging

    The hypothesis the authors' provide is that lower global risk-free rates make risky debt look more attractive on a yield basis, lowering the cost of borrowing from EMEs (hence solvency risk) and increasing investor risk tolerance. This is also consistent with earlier empirical findings.

  2. Supply side policy.

    economic and social returns from higher spending on education - but few deny that "investment in education" has the potential to raise the total stock of skills within the work force and improve the employment prospects of thousands of unemployed workers.

  1. What do you Consider the Key Elements of "New Classical" Macroeconomics? What are the ...

    Therefore, Friedman is suggesting that shifts in aggregate demand have no long-run effects on real GDP. This process is described as the 'natural rate hypothesis'. There has been much controversy surrounding Friedman's analysis. The claim that firm's have more accurate information than is available to workers, has raised many debates among observers.

  2. UK Membership of the European Monetary Union.

    In summary will joining EMU promote higher growth stability and a lasting increase in jobs? * The Maastricht Convergence Criteria * Inflation rate of all Euro countries has to be within 1.5% of the average of the three best performing economies * Long-term interest rates (10 yr rates)

  1. Selecting international modes of entry and expansion

    Many markets have been invented and developed by us. We have a responsibility to our company to not allow some transfer that in the long-run would imperil our business. Wholly-owned subsidiaries Wholly-owned subsidiaries (WOS) offer firms the highest levels of control and the lowest technology risk, but they require the highest resource commitments.

  2. Macroeconomic Equilibrium.

    or a fall in United Kingdom exports following a global downturn. It might also be caused by a cut in government spending or a rise in interest rates which leads to cutbacks in consumer spending. The result of the inward shift of AD is a contraction along the short run

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work