Sample answer

 

(a) With interest rates now higher in Europe than anywhere else European financial assets become more attractive to investors. Hence, the rise in real interest rates in the European Union relative to the rest of the world will lead to a leakage of funds from other countries including the US into Europe. As a result purchases of United States financial assets by foreigners will decrease.

 

(b) The decrease in acquisitions of US assets also means that foreigners will need less US currency, so that the overall demand for dollars will go down. This in turn will lead to the depreciation of the dollar.

 

(c) Now that the dollar has depreciated goods produced in the US cost less in terms of the foreign currency. As a result the international demand for US goods and hence US exports will increase.

 

The effect on the United States imports will be the opposite. The decrease in the international value of the dollar means that each dollar can now buy less foreign commodities so that the purchasing power of US citizens’ income has been diminished. Consequently, Americans will reduce their consumption of foreign goods whose price has gone up relative to their domestic substitutes and US imports will fall.

 

Macroeconomic Policy Debate.

 

Problem 1 (APT’95, P2)

 

Assume that the economy is in a recession.

 

(a) Explain each of the following.

(i) Monetary and fiscal policies advocated by monetarists to eliminate the recession

(ii) Monetary and fiscal policies advocated by Keynesians to eliminate the recession

(b) Explain how monetarists and Keynesians differ in their conclusions about the effects of crowding out associated with the stabilization policies outlined in Part (a).

 

Sample answer:

 

(a) (i) As follows from the name of the school, monetarists deny the effectiveness of fiscal policy, advocating the use of monetary policy only. Hence, in the situation described above monetarists would insist on expanding money supply to bring the economy out of the recession.

(ii) Keynesians, by contrast, would argue against monetary policy on the grounds that it has a very complicated transition mechanism and therefore rarely has the desired impact. According to this school, the most effective way to cure recession is to resort to fiscal expansion either through increasing government expenditures or cutting personal income taxes.

(b) The main reason why monetarists oppose the use of fiscal policy, in contrast to Keynesians who are the foremost advocates of this policy tool, is that the two economic schools differ in their conclusions about the scale of crowding out effect associated with fiscal expansion. Monetarists believe that money demand is rather interest inelastic, whereas investment is very sensitive to changes in the interest rate. Thus, any increase in government purchases or reduction in taxes will inevitably lead to an increase in the interest rate and crowd out an equivalent part of private investment, which renders fiscal policy totally ineffective. Keynesians, on the other hand, share the opposite view as to the elasticities of money and investment demand, which ensures a relatively small size of crowding out effect and justifies the use of fiscal stabilization policy.