Download Answers to Questions in Chapter 23

Answers to Questions in Chapter 23
Note: No. before  indicates a page number
Page
537  Imagine that there is an inflationary gap, but a balance of payments equilibrium.
Describe what will happen if the government raises interest rates in order to close the
inflationary gap. Assume first that there is a fixed exchange rate and then that there is
a floating exchange rate.
Fixed exchange rate: The higher interest rates will reduce aggregate demand and thus
help to close the inflationary gap. The higher interest rates, however, will lead to an
increase in the demand for and a decrease in the supply of dollars: the capital account
will move into surplus, and external balance will be destroyed. The reduction in
inflation will also have the effect of increasing exports and reducing imports, thereby
also improving the current account.
Floating exchange rates: As under a fixed exchange rate, the higher interest rates will
reduce aggregate demand and thus help to close the inflationary gap. The higher
interest rates will lead to an increase in the demand for and a decrease in the supply of
dollars: the capital account will move into surplus, and external balance will be
destroyed. The exchange rate will thus appreciate, thereby restoring external balance.
The effect of the appreciation will be also to reduce the demand for exports (an
injection) and increase the demand for imports (a withdrawal). This will help to
reinforce the effect of higher interest rates in dampening aggregate demand and
restoring internal equilibrium.
From the above it can be seen that monetary policy has a bigger effect on the domestic
economy under floating than under fixed exchange rates.
537  What adverse internal effects may follow from (a) a depreciation of the exchange rate;
(b) an appreciation of the exchange rate?
(a) It may fuel inflation by increasing the price of imported goods and reducing the
need for export industries to restrain cost increases.
(b) It may damage export industries and domestic import-competing industries, which
would now find it more difficult remain competitive.
538  Under what circumstances would (a) deflationary and (b) reflationary policies cause
no conflict between internal and external objectives?
(a) When there was an inflationary gap and a balance of payments deficit.
(b) When there was a deflationary gap and a balance of payments surplus.
540  How would raising interest rates in this way affect the balance between the current and
capital accounts of the balance of payments?
It will have a bigger effect on the capital account. Thus if the capital account had been
in deficit (caused by the `large scale selling of dollars’), it will move back towards
balance. The current account will tend to deteriorate, however, as a result of the higher
exchange rate, although this will be to some extent offset by the reduction in aggregate
demand (and hence demand for imports) caused by the higher interest rates.
541  (Box 23.1) Why do you think the Reserve Bank was concerned by the fall in the
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exchange rate?
The Reserve Bank has a policy objective to keep inflation in the range of 2-3% (see
Chapter 19). The substantial fall in the exchange rate will have led to a rise of a similar
magnitude in the Australian dollar price of imports. This in turn will have increased the
price level increasing the rate of inflation, and threatening the achievement of the
inflation target.
543  (Box 23.2) 1. Suppose that under a dirty floating system the government is worried
about high inflation and wants to keep the exchange rate up in order to prevent import
prices rising. To tackle the problem of inflation it raises interest rates. (Similar policies
have been pursued in recent years.) What will happen to the current and capital
accounts of the balance of payments?
The high interest rates will cause a surplus on the capital account. The higher exchange
rate will cause a deficit on the current account.
544  Why will excessive international liquidity lead to international inflation?
Because countries can use the extra reserves to finance the purchase of extra imports.
The extra liquidity is thus equivalent of an increase in `world money supply'. If this
grows faster than world trade, then there will be a problem of excess demand and
demand-pull inflation.
545  To what extent do Keynesians and new classicists agree about the role of fixed
exchange rates?
They are both critical, as pages 543-5 make clear. They both argue that monetary
policy is relatively ineffective under fixed exchange rates, and that overall imbalance
on the balance of payments may persist.
545 If this is the case, should firms worry about losing competitiveness in world markets if
domestic inflation is higher than world inflation?
Yes, because (in the example given) the demand for Australian goods in Japan will fall.
They will be less competitive with Japanese produced goods and with Japanese imports
from other countries.
546  Will there be any cost to the Australian economy from a decline in the demand for
exports resulting from a world recession?
Yes. The depreciation in the exchange rate will reduce the demand for imports (unless
the world recession causes the foreign currency price of imports to fall by the same
percentage that the exchange rate depreciates). A reduction in imports will mean that
the exchange rate does not have to fall so far and thus the level of exports will not be
fully maintained. There is thus a cost to the export sector. This effect will be partly or
even wholly offset, however, by the boost to aggregate demand (and hence a further
reduction in the exchange rate) caused by the fall in imports (a withdrawal).
548  (Box 23.4) 1. If the Malaysian ringgit is undervalued by 53% in PPP terms against the
US dollar, and the Swiss franc overvalued by 39%, what implications does this have
for the interpretation of Malaysian, Swiss and US GDP statistics?
The GDP figures understate the purchasing value of Malaysian national income by
53% relative to US national income, and overstate the purchasing value of Swiss
national income by 39% relative to US national income. In other words, at the
exchange rates in question, Malaysian national income seems 53% lower relative US
national income than it really is in purchasing terms, and Swiss national income seems
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Answers to questions in Economics by Sloman and Norris
39% higher relative to US national income than it really is in purchasing terms.
549  Why would banks not be prepared to offer a forward exchange rate to a firm for, say,
five years' time?
It would involve too much risk. The longer the time period the greater the scope for
movements in the exchange rate and the more unpredictable they become.
550  (Box 23.5) Why do high international capital mobility and an absence of exchange
controls severely limit a country's ability to choose its interest rate?
Because if its interest rate were lower than international rates, there would be a massive
outflow of capital if international capital were highly mobile and there were an absence
of exchange controls. The resulting fall in the money supply would push the interest
rate up to the international level. Similarly if its interest rate were higher than
international rates, the resulting massive inflow of capital would increase the money
supply and drive its interest rate down to the international level. These effects are
stronger if the country is attempting to peg its exchange rate.
551  What could be done to stop the exchange rate appreciating?

Central bank sales of the domestic currency on the foreign exchange market,
thereby building up reserves.

Reducing interest rates.

Removing exchange controls.

Reflationary fiscal and monetary policy.
554  1. Why did the ‘contagion’ spread to countries outside South-East Asia?
For several reasons: (a) The events made leaders of capital more risk averse and firms
throughout the world find ti more difficult to borrow overseas; (b) It caused speculative
pressure on other currencies; (c) It reduced the level of exports to South-East Asian
countries.
554  (Box 23.6) What policy measures could the South-East Asian countries have adopted
before the crisis to prevent it occuring?
551  What could be done to stop the exchange rate appreciating?
They could have adopted floating exchange rates and hence prevented the over
valuation of their currencies. They could have supervised back lending and imposed
prudential rules.
556  Assume that the United States economy expands. What wil determine the size of the
multiplier?
The size of the initial import of the growth in a country’s exports to the USA will
depend upon (a) how open the economy is, (b) the proportion of the exports that go to
the USA. This impact is thus multiplied by the mornal multiplier, whose magnitude
depends on the marginal propensities to consume and import and on tax rates (see
Appendix to Chapter 17).
557  Are exports likely to continue growing faster than GDP indefinitely? What will
determine the outcome?
There is no reason why they should not grow faster than GDP – after all they have
done so for the last half century. By definition imports grow at the same rate and this
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trade reflects the advantage of specialisation and the desire of consumers to have a
wide choice of products. The rate of growth of exports will depend largely on how
successful policies are to further liberalise trade.
558  Give some examples of beggar-my-neighbour policies.
Tariffs, quotas, export subsidies, ‘buy Australian’ schemes.
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