This is a solution of Policy Implications Open Economy Framework in which we discuss fixed exchange rates government policies can help your company cope with aging systems and limited resources that can lead to fragmented IT solutions.

Policy Implications Open Economy Framework

IntroduPolicy Implications Open Economy Frameworkction

Under a system of fixed exchange rates government policies have different implication than under floating rates. Monetary policy is not at all effective under fixed exchange rate whereas fiscal policy can be very effective. In this chapter we see the effect of these policies under the assumptions of the AA-DD model. We also consider a case study about the fall of the Bretton Woods fixed exchange rate system started after World War II. This chapter will make the AA-DD model its base to analyse the effects of fiscal, monetary, and exchange rate policy under a system of fixed exchange rates. Fiscal and monetary policies are the major tools governments use to run their economies. With the help of fixed exchange rates, a third policy can also be used that is, exchange rate policy. There are exchange rate changes due to policy. These exchange rate changes are called devaluations and revaluations.

We see the effect of monetary policy in the economy. Suppose expansionary monetary policy is conducted then the money supply in the economy will increase. An increase in money supply will lead to a reduction in U.S. interest rates. This in turn will make domestic assets less attractive. As a result investors demand for pounds will increase. Would it have been a floating exchange system, excess demand for pounds would have resulted in depreciation of dollar vis-a –vis pound. But in case of a fixed exchange rate, excess demand for pounds will have to be settled by Fed. The Fed will supply the excess pounds demanded by selling reserves of pounds in exchange for dollars at the fixed exchange rate.

The sales of foreign currency result in a reduction in the U.S. money supply. This is because when the Fed buys dollars in the private forex but will reduce the domestic money supply. This will causes AA to shift back down, the finally the AA curve returns to its original position. The AA curve goes because the exchange rate has to be fixed at Ē$/£. This implies that the money supply is reduced in the end which will exactly offset the money supply expansion caused initially due to expansionary monetary policy. So, in a nut shell the money supply will rise for a short term but then will fall back to its original level. So monetary policy is ineffective

Now we see the effect of fiscal policy in the economy. Suppose expansionary fiscal policy is conducted then the aggregate demand in the economy will increase. An increase in aggregate demand will increase the GNP in economy. Now increase in income will lead to increase in money demand. This will result in increase in U.S. interest rates. This in turn will make domestic assets more attractive. As a result investors demand for dollars will increase. Would it have been a floating exchange system, excess demand for dollars would have resulted in appreciation of dollar vis-a –vis pound. But in case of a fixed exchange rate, excess demand for pounds will have to be settled by Fed. The Fed will supply the excess dollars demanded by increasing the money supply in the economy by buying reserves of pounds. This will causes AA to shift right, the finally the AA curve reaches the new equilibrium position. The AA curve goes right because the exchange rate has to be fixed at Ē$/£. Now what happens finally is that GNP increases in the new equilibrium with no change in exchange rate in short run. There was always the pressure on exchange rate to fall but it was never allowed to fall as Fed used its adjustment mechanism. So we encounter a fall in current account balance and an increase in trade deficit.Unit 6 Computer Systems Assignment

Lastly we note the concepts of devaluation and revaluation. A devaluation which happen in a fixed exchange rate system will lead to an increase in GNP, an increase in the exchange rate to the new short run value of exchange rate that has been fixed by Fed and also lead to an increase in the current account balance. A revaluation which happens in a fixed exchange rate system will lead to a decrease in GNP, an increase in the value of currency to the new exchange rate fixed, and lead to a decrease in the current account balance. Balance of payments crises can be anticipated by investors in different economies.. When they happen to be anticipated they will result in capital flight, which usually exacerbate the balance of payments crisis as it reduces the foreign reserves all the more quickly and this leads to worsening of crisis.

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