International Monetary Economics

AA-DD QUESTIONS

1. Using the AA-DD model explain why under credible fixed exchange rate, temporary monetary policy is ineffective whereas under floating exchange rate it is effective in rising output.

2. Use the asset market and money market figure to study the short run effects of a change in market belief with regards to the fixed exchange rate, in particular assume market participants expect the government to devaluate. Is the effect different from a change in market beliefs with regards to a flexible exchange, in particular assume market participants expect a depreciation?

3. If a government initially has a balanced budget but then cuts taxes temporarily, it is running a deficit that it must somehow finance. Suppose people think the government will finance its deficit in the future by printing the extra money it now needs to cover its expenditures. Would you still expect the tax cut to cause a currency appreciation in the short run? Would you still expect the tax cut to cause an increase in output in the short run? (Use the AA-DD model to answer this question).

SPECULATIVE ATTACK

4. Suppose that the Malaysian ringgit is pegged to the US dollar at 2.5 ringgit/$. The central bank of Malaysia has $1 billion of international reserves left. Malaysian banks offer short term loans and deposits for any amount at an interest rate of 10%. Agents expect that if foreign reserves are exhausted, the Malaysian ringgit will depreciate to 3 ringgit/$. How would you attack the peg if you were a speculator? How much profit can you make?

POLICY TRILEMMA

5. Policymakers around the world often face what Obstfeld and Taylor dubbed a 'policy trilemma':

• they want to fix the nominal exchange rate, in order to stabilize the price level;
• they want capital mobility for efficiency and flexibility purposes;
• they want to engage in active monetary policy for output stabilization purposes.

Using the concepts you have learned in class, explain in detail why this is a 'trilemma', i.e. why only two of the three objectives can be achieved at any point in time.