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Chapter 17 Monetary Policy And Exchange Rates

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ECON 2035
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Chapter 17Monetary Policy and Exchange Rates 171 Exchange Rates and Stabilization Policy Changes in monetary policy will affect the real exchange rate but sometimes shocks to the real exchange rate will affect the economy so that the central bank will respond with policy changes Suppose that confidence in the economy of a country improvesThis will attract foreign investment resulting in a decrease of net capital outflowsappreciation of currency oNet exports in decreasing Everything else held constant this will cause an appreciation in the exchange rate oOutput decreaesoDecrease in net capital outflows will appreciate the real exchange rateAt the higher value of the real exchange rate there will be less net exports which will cause a decrease in aggregate expenditures If the central bank does not change the real interest rate then aggregate output will fall oThis will cause the inflation rate to falla rise in confidence causes a recession and inflation rate falls and a confidence causes an economic boom and an increasing inflation rate If the central bank wants to stabilize the economy then the central bank will adjust the real interest rate to keep output at potential oIncreasing confidence decreases net capital outflows appreciating the real exchange rate decreasing aggregate expenditures Central bank to keep aggregate output at potential will decrease the real interest rate oThis will increase net capital outflows but net capital outflows will still be below the original level The real exchange rate will still be below the original level but not as high as if the central bank didnt react The decrease in net capital outflows from the increase in confidence is greater than the increase in net capital outflows from the central bank action which has to do with the components of aggregate expenditure oThe real exchange rate is higher than the original level thus net exports are lower but since the real interest rate is lower consumption and investment are higher Aggregate output is constant at the higher value of the real exchange rate While fluctuation in the real exchange rate do cause instability in inflation and aggregate output the strength of this effect depends on how important trade is to the economywhat percent of GDP is exports Country like the UStrade is relatively small proportion of GDPCountries like Canada exports are around 80 of GDPpay close attention to exchange rate movements 172 Costs of ExchangeRate VolatilityFluctuations in exchange rate have other effects on the economy Exchange rate appreciatesoImporters are better off because imported goods are less expensive oForeign owners of domestic assets are better off because these assets have increased in valueoExporters are worse off because their goods are now more expensive to foreign buyersoDomestic owners of assets worse off because their assets have decreased in value Opposite true if exchange rate depreciates If the exchange rate fluctuates this will cause risk to increase oOver the shortterm firms and asset holders can reduce this exchangerate risk by trading exchangerate futuresoHowever since futures contracts are rarely longer than 6 months longterm fluctuations will be difficult to hedge against For firms these longer term fluctuations may induce them to search for domestic suppliers and domestic markets to sell their goods in oExchangerate risk will cause the expected return on foreign investments to decrease thus the incentive will be to decrease the amount of foreign investments and increase domestic investmentExchangerate volatility will induce a decline in international capital flows 173 ExchangeRate Policies Central bankers have different policies available to them if they want to try to stabilize exchangerate fluctuationsCentral bank can change the real interest to affect the real exchange rate
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