International Economics Study Set 9
Quiz 22 :
Internal and External Balance With Fixed Exchange Rates
Since the government here has achieved external balance with the fixed rate regime, the fiscal policy to increase spending is to regain the internal balance as the unemployment is stated to be high. Such a policy will have effects by improving the gross domestic production which will indeed lead to creation of employment and tackle the issue of unemployment however could lead to devaluation of the currencies. If the central bank uses an unsterilized intervention to defend the fixed rate, this can cause a rebound on the fiscal policy taken hereafter to regain internal balance, this also could cause a swing to the external balance as well.
The assignment rule stipulated by Robert Mundell suggests to assign to fiscal policy the task of stabilizing the domestic economy and assign to monetary policy the task of stabilizing the balance of payments making each arm of policy to fully concentrate on a single task making this very handy for policy makers. The assignment rule thus leads the economy to follow a less direct route to the goal of internal and external balance. The advantages of having this policy are 1. Each arm of the policy concentrates on single task making this very handy for policy makers 2. Follows a less direct rule to attain the goal of internal and external balance The major drawbacks of this policy are 1. It may not work completely in practice as against theory 2. A lag in response either from the economy or the decision makers can lead to oscillation in the short-medium run which can be worse than having no policy at all
a. By selling USD10 billion in the foreign exchange market the Pugelovian government has reduced the official reserves of USD and the central bank liabilities which can protect it during external shocks and thus have a lower threshold of support but in the short run it can help prevent the domestic currency to fall further b. Sterilization increases the central banks holding of domestic currencies which in turn increases its liabilities. Though it does not improve its external balance nor the money supply it could change the equilibrium point and a change in the LM curve. c. An open market operation would indicate an injection of money supply into the open market which in turn creates more domestic currency available to the consumers, this will increase its liabilities and if not balanced out effectively can reduce the value of currency.