Suppose that Mexico experiences a shock that exogenously increases money demand. (Note, this is an exogenous shift in money demand, not an endogenous response to some other variable in the money demand function.) Study how this shock can cause a recession, and how policy makers can respond to it. Assume a flexible exchange rate.
For the scenarios below (a and b), show the effect of the money demand shock and the policy response to it. You should include the IS/LM, money market, and FOREX market diagrams. Please label curves as follows:
- Point A: initial equilibrium
- Point B: effect of the money demand shock without a policy response
- Point C: effect of the money demand shock with a policy response.
- You must state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, CA.
For simplicity, assume here that MPCF = 0. This implies that the trade balance and current account are just a function of the real exchange rate and not income.
a) Suppose that monetary policy is used as stabilization policy, which maintains the level of output at its initial value despite the money demand shock.
b) Now suppose that instead, a fiscal policy of a tax cut is used as stabilization policy, keeping the level of output fixed at its initial value. (No monetary policy used here).
If Mexico already has a current account deficit that it does not want to make worse, discuss whether you would recommend it use monetary or fiscal policy as stabilization policy here.