Question

1. (10 points) Milton Friedman has pointed out that when expansionary fiscal policy is used to increase real GDP, some private investment will be crowded out. Expansionary monetary policy will usually increase real GDP, by increasing autonomous consumption expenditures and private investment will expansionary monetary policy have the same beneficial effect on autonomous consumption and private investment for a large country in a global economy? Analyze both the fixed and flexible exchange rate cases and explain why the BP line is upward-sloping as part of your answer

Answer 1

Answer:

Flexible Exchange Rate When expansionary financial arrangement is executed then it implies cash supply has been expanded. The underlying effect of cash supply increment is that the loan cost falls. This happens because for a given level of income people will have more money in their hands which they will use to increase their speculative balances. To keep the money market in equilibrium the interest rate will fall. Decrease in the loan cost will bring about increment in the venture as firms think that its less expensive to obtain to buy hardware and gear or to put resources into plants. The increase in investment will cause income to increase in the economy and as a result consumption will also increase. In any case, since there is adaptable conversion scale so it implies that the decrease in the financing cost will cause capital surge from the nation. This will put pressure on the conversion scale to deteriorate. The depreciation will make exports of the country competitive while making imports cheaper. This situation will provide additional push to the income level and incomes will rise further. So, the aggregate demand curve on the whole will shift upward to the right.

Fixed Exchange Rate On account of fixed swapping scale decrease in the financing cost because of cash supply increment will cause capital outpouring from the nation. This will put pressure on the exchange rate to depreciate. However, since there is fixed exchange rate so the Central Bank will intervene in the foreign exchange market and will supply the foreign currency and buy domestic currency. As a result, money supply will decline and the economy will move back to the initial position. This is because buying of domestic currency will reduce money supply that will cause the interest rate to rise after the initial fall. The rise in the interest rate will continue till the time the effect of initial investment increase is fully crowded out. The BP line shows the various combinations of interest rates and income levels for which the Current Account and Capital Account offset each other, or in other words the Balance of Payments remain in equilibrium. The motivation behind why it is upward inclining is that expansion in the salary will cause expanded interest for utilization great that will incorporate imported merchandise. This will create deficit in the Current Account. To offset it equivalent amount of capital inflow is needed. Capital inflow is possible if the domestic interest rate rises that attract investment from foreign investors.