Consider The Case Of An Exogenous Increase In Payments

Consider The Case Of An Exogenous Increase In Payments Into A Country

Consider the case of an exogenous increase in payments into a country. 1. In a Mundell-Fleming model, what will be the effects on a country's nominal and real exchange rate and GDP under: a) Fixable exchange rates b) Fixed exchange rates with sterilization c) Fixed exchange rates without sterilization 3. Now answer question 1 using a simple monetary model.

Paper For Above instruction

Introduction

An exogenous increase in payments into a country—such as sudden foreign investment, aid, or export revenue—can significantly influence its exchange rates, price levels, and economic output. To analyze these effects comprehensively, macroeconomic models such as the Mundell-Fleming model and simplified monetary frameworks are employed. This paper explores the outcomes under various exchange rate regimes, specifically fixed and sterilized/unst sterilized systems, and compares these with insights derived from a simple monetary model.

Theoretical Background

The Mundell-Fleming model provides a framework for understanding macroeconomic equilibria under different exchange rate regimes in an open economy, considering short-term capital mobility and monetary-fiscal policy interactions. The simple monetary model, on the other hand, focuses on the equilibrium determined by money supply, demand, and price levels, offering a more streamlined perspective on exchange rate and output responses.

Effects in the Mundell-Fleming Model

a) Fixable (Pegged) Exchange Rate Regime:

When a country maintains a fixed exchange rate, an exogenous inflow of payments initially increases the domestic money supply, leading to an appreciation of the nominal and real exchange rates. The initial appreciation enhances the country’s competitiveness temporarily but also increases foreign exchange reserves. To sustain the peg, the central bank must intervene by selling foreign currency reserves, which eventually neutralizes the initial impact on the money supply, restoring the equilibrium.

In terms of output and GDP, the initial inflow can cause an expansion, as the country’s goods become more competitive and demand rises. However, consistent intervention and sterilization efforts maintain exchange rate stability, which means that over time, the net effect on real GDP depends on the scale and duration of interventions. Without sterilization, the accumulation of foreign reserves leads to an increase in the domestic money supply, potentially resulting in inflationary pressures if sterilization measures are inadequate.

b) Fixed Exchange Rates with Sterilization:

Sterilization involves offsetting the impact of foreign exchange interventions to prevent changes in the domestic monetary base. When the exogenous increase in payments occurs, the central bank intervenes by selling foreign reserves and simultaneously absorbing the equivalent domestic currency, effectively sterilizing the inflow.

This process maintains monetary neutrality and prevents the appreciation of the exchange rate. Consequently, the nominal and real exchange rates remain relatively stable, and the GDP's response is muted in the short run. Nevertheless, if sterilization is imperfect or too costly, it can lead to accumulation of interest payments and possible distortions, affecting long-term growth.

c) Fixed Exchange Rates without Sterilization:

Without sterilization, the inflow of foreign payments increases the monetary base directly, causing the domestic currency to appreciate. The appreciation reduces export competitiveness, potentially dampening GDP growth in the medium term. The expanded money supply can also spark inflationary pressures, especially if the central bank accommodates the inflow by increasing the monetary base.

In this scenario, the exchange rate appreciation is persistent, and the economy might experience a slowdown in external demand for domestic goods, impacting overall output adversely. The government faces a dilemma between maintaining the peg and controlling inflation, often leading to continued reserve depletion.

Analysis Using a Simple Monetary Model

The simple monetary model posits that the exchange rate is determined by the relative supply and demand for money, linked to price levels and income. An increase in foreign payments inflates international reserves, affecting domestic money supply and asset holdings.

In the model, if the central bank keeps the money supply constant, the initial inflow of foreign funds appreciates the domestic currency, raising the exchange rate. The resulting higher currency value reduces net exports, leading to a decline in net exports-driven GDP unless offset by other factors. Conversely, if the central bank increases money supply to accommodate the inflow, inflation may ensue, depreciating the real exchange rate over time.

Under fixed exchange rate commitments, the central bank may intervene to prevent currency appreciation, with sterilization maintaining monetary neutrality. In contrast, without sterilization, the domestic money supply expands, causing inflation and potentially undermining price stability.

The simple monetary model indicates that the effect on GDP largely depends on whether the central bank sterilizes the inflows and how it manages the money supply, emphasizing the pivotal role of monetary policy in macroeconomic stability.

Conclusion

An exogenous increase in payments influences a country's macroeconomic variables differently depending on the exchange rate regime and sterilization policy. Under fixed rates, interventions temporarily stabilize the exchange rate but may distort monetary conditions if not sterilized. Sterilization effectively neutralizes the impact on the money supply, stabilizing inflation and output but may impose financial costs. The simple monetary model corroborates these findings, highlighting the importance of monetary policy in stabilizing the effects of external shocks. Policymakers should carefully consider the trade-offs involved in sterilization and exchange rate management to sustain economic stability and growth.

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