Worth: Mankiw Economics 5e 322 PART IV Business Cycle Theory: The Economy in the Short Run figure 12-7 (a) The Equilibrium Exchange Rate Is Greater (b)The Equilibrium Exchange Rate Is Less Than the Fixed Exchange Rate Than the Fixed Exchange Rate Exchange rate, e LM LMA Exchange rate, e Fixed exchange Fixed exchange rate rate nge IS* How a Fixed Exchange Rate Governs the Money Supply In panel (a), the equilibrium exchange rate initially exceeds the fixed level. Arbitrageurs will buy foreign currency in increases the money supply, shifting the LM*curve to the right and lowering the exchange rate. In panel (b), the equilibrium exchange rate is initially below the fixed level. Arbitrageurs will buy dollars in foreign-exchange markets and use them to buy foreign currency from the Fed. This process automatically reduces the money supply, shifting the LM* curve to the left and raising the exchange rate. rise in the money supply shifts the Lm curve to the right, lowering the equilib- rium exchange rate. In this way, the money supply continues to rise until the equilibrium exchange rate falls to the announced level Conversely, suppose that when the Fed announces that it will fix the ex- change rate at 100 yen per dollar, the equilibrium is 50 yen per dollar. Panel (b) of Figure 12-7 shows this situation. In this case, an arbitrageur could make a profit by buying 100 yen from the Fed for $1 and then selling the yen in the marketplace for $2. When the Fed sells these yen, the $I it receives automati- cally reduces the money supply. The fall in the money supply shifts the LM curve to the left, raising the equilibrium exchange rate. The money supply continues to fall until the equilibrium exchange rate rises to the announced level It is important to understand that this exchange-rate system fixes the nominal exchange rate. Whether it also fixes the real exchange rate depends on the time horizon under consideration. If prices are flexible, as they are in the long run, then the real exchange rate can change even while the nominal exchange rate is fixed. Therefore, in the long run described in Chapter 5, a policy to fix the nominal exchange rate would not influence any real variable, including the real exchange rate. A fixed nominal exchange rate would influence only the money supply and the price level. Yet in the short run described by the Mundell-Fleming model, prices are fixed, so a fixed nominal exchange rate implies a fixed real exchange rate as well User JoENA: Job EFFo1428: 6264_ch12: Pg 322: 27517#/eps at 100sm Mon,Feb18,200212:44
User JOEWA:Job EFF01428:6264_ch12:Pg 322:27517#/eps at 100% *27517* Mon, Feb 18, 2002 12:44 AM rise in the money supply shifts the LM* curve to the right, lowering the equilibrium exchange rate. In this way, the money supply continues to rise until the equilibrium exchange rate falls to the announced level. Conversely, suppose that when the Fed announces that it will fix the exchange rate at 100 yen per dollar, the equilibrium is 50 yen per dollar. Panel (b) of Figure 12-7 shows this situation. In this case, an arbitrageur could make a profit by buying 100 yen from the Fed for $1 and then selling the yen in the marketplace for $2.When the Fed sells these yen, the $1 it receives automatically reduces the money supply. The fall in the money supply shifts the LM* curve to the left, raising the equilibrium exchange rate. The money supply continues to fall until the equilibrium exchange rate rises to the announced level. It is important to understand that this exchange-rate system fixes the nominal exchange rate.Whether it also fixes the real exchange rate depends on the time horizon under consideration.If prices are flexible,as they are in the long run,then the real exchange rate can change even while the nominal exchange rate is fixed. Therefore, in the long run described in Chapter 5, a policy to fix the nominal exchange rate would not influence any real variable, including the real exchange rate.A fixed nominal exchange rate would influence only the money supply and the price level.Yet in the short run described by the Mundell–Fleming model, prices are fixed, so a fixed nominal exchange rate implies a fixed real exchange rate as well. 322 | PART IV Business Cycle Theory: The Economy in the Short Run figure 12-7 Exchange rate, e Exchange rate, e Income, output, Y Income, output, Y Equilibrium exchange rate Fixed exchange rate Fixed exchange rate Equilibrium exchange rate (a) The Equilibrium Exchange Rate Is Greater Than the Fixed Exchange Rate LM*1 LM*2 LM*1 LM*2 IS* (b) The Equilibrium Exchange Rate Is Less Than the Fixed Exchange Rate IS* How a Fixed Exchange Rate Governs the Money Supply In panel (a), the equilibrium exchange rate initially exceeds the fixed level. Arbitrageurs will buy foreign currency in foreign-exchange markets and sell it to the Fed for a profit. This process automatically increases the money supply, shifting the LM* curve to the right and lowering the exchange rate. In panel (b), the equilibrium exchange rate is initially below the fixed level. Arbitrageurs will buy dollars in foreign-exchange markets and use them to buy foreign currency from the Fed. This process automatically reduces the money supply, shifting the LM* curve to the left and raising the exchange rate
Worth: Mankiw Economics 5e CHAPTER 12 Aggregate Demand in the Open Economy 323 The International Gold standard During the late nineteenth and early twentieth centuries, most of the worlds major economies operated under a gold standard. Each country maintained a re- serve of gold and agreed to exchange one unit of its currency for a specified mount of gold. Through the gold standard, the world's economies maintained a system of fixed exchange rates To see how an international gold standard fixes exchange rates, suppose that the U.S. Treasury stands ready to buy or sell 1 ounce of gold for $100, and the Bank of England stands ready to buy or sell 1 ounce of gold for 100 pounds. To- gether, these policies fix the rate of exchange between dollars and 1 must trade for 1 pound. Otherwise, the law of one price would be violated, and that the exchange rate 2 pounds per dollar. I this case, an arbitrageur could buy 200 pounds for $100, use the pounds to buy 2 ounces of gold from the Bank of England, bring the gold to the United States, and sell it to the Treasury for $200--making a $100 profit. Moreover, by bringing the gold to the United States from England, the arbitrageur would in- crease the money supply in the United States and decrease the money supply in Engl Thus, during the era of the gold standard, the international transport of gold by arbitrageurs was an automatic mechanism adjusting the money suppl and stabilizing exchange rates. This system did not completely fix exchange rates, because shipping gold across the Atlantic was costly. Yet the international gold standard did keep the exchange rate within a range dictated by trans- portation costs. It thereby prevented large and persistent movements in ex- change rates Fiscal Policy Let's now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes. This policy shifts the IS curve to the right, as in Figure 12-8, putting upward pressure on the exchange rate. But because the central bank stands ready to trade foreign and domestic cur- rency at the fixed exchange rate, arbitrageurs quickly respond to the rising ex- change rate by selling foreign currency to the central bank, leading to an automatic monetary expansion. The rise in the money supply shifts the LM curve to the right. Thus, under a fixed exchange rate, a fiscal expansion raises ag- gregate income 2 For more on how the gold standard worked, see the essays in Barry Eichengreen, ed, The Gold Standard in Theory and History(New York: Methuen, 1985) User JoENA: Job EFFo1428: 6264_ch12: Pg 323: 27518#/eps at 100sm Mon,Feb18,200212:45
User JOEWA:Job EFF01428:6264_ch12:Pg 323:27518#/eps at 100% *27518* Mon, Feb 18, 2002 12:45 AM Fiscal Policy Let’s now examine how economic policies affect a small open economy with a fixed exchange rate. Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes.This policy shifts the IS* curve to the right, as in Figure 12-8, putting upward pressure on the exchange rate. But because the central bank stands ready to trade foreign and domestic currency at the fixed exchange rate, arbitrageurs quickly respond to the rising exchange rate by selling foreign currency to the central bank, leading to an automatic monetary expansion. The rise in the money supply shifts the LM* curve to the right.Thus, under a fixed exchange rate, a fiscal expansion raises aggregate income. CHAPTER 12 Aggregate Demand in the Open Economy | 323 CASE STUDY The International Gold Standard During the late nineteenth and early twentieth centuries, most of the world’s major economies operated under a gold standard. Each country maintained a reserve of gold and agreed to exchange one unit of its currency for a specified amount of gold.Through the gold standard, the world’s economies maintained a system of fixed exchange rates. To see how an international gold standard fixes exchange rates, suppose that the U.S.Treasury stands ready to buy or sell 1 ounce of gold for $100, and the Bank of England stands ready to buy or sell 1 ounce of gold for 100 pounds.Together, these policies fix the rate of exchange between dollars and pounds: $1 must trade for 1 pound. Otherwise, the law of one price would be violated, and it would be profitable to buy gold in one country and sell it in the other. For example, suppose that the exchange rate were 2 pounds per dollar. In this case, an arbitrageur could buy 200 pounds for $100, use the pounds to buy 2 ounces of gold from the Bank of England, bring the gold to the United States, and sell it to the Treasury for $200—making a $100 profit. Moreover, by bringing the gold to the United States from England, the arbitrageur would increase the money supply in the United States and decrease the money supply in England. Thus, during the era of the gold standard, the international transport of gold by arbitrageurs was an automatic mechanism adjusting the money supply and stabilizing exchange rates. This system did not completely fix exchange rates, because shipping gold across the Atlantic was costly.Yet the international gold standard did keep the exchange rate within a range dictated by transportation costs. It thereby prevented large and persistent movements in exchange rates.2 2 For more on how the gold standard worked, see the essays in Barry Eichengreen, ed., The Gold Standard in Theory and History (New York: Methuen, 1985)