Problem Focused Exercise: Macroeconomic adjustment and EMU
1
Read the attached extract from, The exchange rate and macroeconomic
adjustment: EMU study, HM Treasury and complete the following tasks.
Task 1
Answer the following questions assuming firstly a fixed exchange rate and then
secondly a floating exchange rate.
The article takes an example of an economic shock that leads to an increase in
demand for UK exports when the UK economy is already operating at full
employment.
(a) What is the initial impact of this shock on the economy?
(b) What further repercussions does this have on the economy?
Illustrate your answers using an economic model, illustrating this with a diagram.
feedback page 3
Task 2
In the paragraph labelled 12 the extract considers what happens if a shock leads to
a decrease in demand and suggests that this may lead to wage cuts (or at least
lower wage rises) under fixed exchange rates.
(a)
Explain why this is likely under fixed but not under floating exchange
rates.
(b)
Analyse why the adjustment under fixed exchange rates may take
some time and may prove painful if wage cuts (or even lower wage
rises) are required, using the short run and long-run Phillips curve.
feedback page 4
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Macroeconomic adjustment and EMU
2
Extract from: The exchange rate and macroeconomic adjustment: EMU study
HM Treasury
7. The real exchange rate provides one of the adjustment mechanisms that balances
aggregate demand and aggregate supply in the medium and long run. The real exchange
rate is defined as the nominal (or market) exchange rate adjusted for price levels at home
and abroad, and is a measure of the relative competitiveness of domestic and foreign
production.
8 If the UK were to join EMU then there would no longer be a nominal exchange rate
between the UK and the current euro area countries. Within EMU, if a shock occurred that
required a change in the real exchange rate, this could only be achieved if UK inflation
were different from the rest of the euro area for a period of time. Outside of EMU, part or all
of any real exchange rate adjustment may be achieved by a change in the nominal
exchange rate.
9 This point may be illustrated by a simple example. Consider an economic shock that leads
to excess demand for UK production, for example an increase in demand for UK exports
when the UK economy is already operating at full capacity. When exchange rates are fixed,
this excess demand will put upward pressure on UK inflation, leading to a real exchange rate
appreciation. This will encourage a switching of demand towards foreign suppliers and a
switching of supply towards domestic markets. Both effects reduce, and eventually
eliminate, the initial excess demand.
10 By contrast, when nominal exchange rates are flexible, the effect of increased demand
for UK exports may cause the nominal exchange rate to appreciate. This provides an
alternative route for securing the real exchange rate appreciation needed to eliminate the
initial excess demand.
11 A country’s real exchange rate will ultimately reflect underlying economic conditions,
irrespective of whether nominal exchange rates are fixed or floating. But the adjustment
mechanism is different, with adjustment in the domestic price level being greater under a
fixed exchange rate regime. Under flexible exchange rates, the movement in the nominal
exchange rate cushions some of the impact on the domestic price level, and consequently
can be viewed as a shock absorber.
12 The chief advantage of a flexible exchange rate regime is that the nominal exchange
rate can react rapidly to changes in economic conditions. Under a fixed exchange rate
regime, changes to the level of domestic prices may take longer to occur. This may be
especially important when a real exchange rate depreciation is needed, as under a fixed
exchange rate system, this would require inflation to be lower than in other countries, and
may even require wage cuts. Under both regimes the eventual real effects on the economy
will be the same; real relative prices are adjusting even if it is nominal exchange rates that
are facilitating the adjustment.
treasury.gov.uk./documents/international_issues/the_euro/assessment/studies/euro_assess03
_studwarwickshire.cfm
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Macroeconomic adjustment and EMU
3
Feedback Task 1
We illustrate the relationships using the flow diagrams below.
What is the initial impact?
* Under a fixed exchange rate the initial impact is to increase excess demand,
which leads to inflation.
* Under a floating exchange rate although excess demand is again raised, there
is also an immediate impact on the nominal exchange rate, increasing this as
the demand for pound sterling is increased.
What further repercussions does this have on the economy?
Under both fixed and floating exchange rates this will lead to an increase in the real
exchange rate and from then the mechanism is the same. Exports fall (injection),
imports (withdrawal) rise and the excess demand falls until aggregate demand
returns to its original level,
Fixed Exchange Rate
↑ demand
↑excess
UK exports
demand
↑inflation
↑real
exchange rate
↓exports
↑imports
↓excess
demand
Floating Exchange Rate
↑ demand
UK exports
↑excess
demand
↑nominal
exchange rate
↓excess
demand
↑real exchange rate
↓exports
↑imports
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Macroeconomic adjustment and EMU
4
Feedback Task 1(cont)
What economic model should we use?
Since the changes in the economy identified above involved inflation and
aggregate demand, using the AD/AS framework is appropriate.
Using this model:
* In this case, under both mechanisms AD is increased, as exports are
injections into the economy, shifting from AD1 to AD2. There is inflationary
pressure in the economy as income increases above the full employment
level (YF), with prices rising from P1 to P2.
* With a fixed exchange rate the increase in the price level increases the
real exchange rate and this lowers aggregate demand until it returns to its
original equilibrium level.
* With a floating exchange rates, as we have seen above, there is also an
immediate impact on the nominal exchange rate. This means that the initial
rise in AD is likely to be less and the return to full employment equilibrium
quicker.
Price
level
AS
P2
P1
AD2
AD1
YF
Y2
National
Income
(Note: there are also other forces that help restore equilibrium to YF - the
price rise will lower the real quantity of money in the economy, increasing
interest rates and decreasing investment and consumption on things like
durable goods, hence also lower aggregate demand.)
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Macroeconomic adjustment and EMU
5
Feedback Task 2
What happens if aggregate demand initially falls?
We have the opposite changes from the flow diagrams in task 1 and aggregate
demand is at first reduced.
* For the fixed exchange rate regime this means to return to equilibrium at YF, we
need inflation to fall and how much this needs to be depends on the inflation of
our competitors. We need our prices, relative to theirs, to reduce. This can even
mean a fall in prices (that is negative inflation). This fall in inflation means a fall in
wage increases, or in the case of negative inflation, wage falls. This may be a
painful process and take time as expectations have to adjust downwards and
unemployment may result. That is the economy remains ‘stuck’ at less than full
employment for a long time. The pressures towards long-run equilibrium at full
employment are painful for the economy, may be weak and take some time.
* In the flexible exchange rate case the adjustment is by the nominal exchange
rate, not inflation, so this is not as painful and the economy moves back towards
full employment equilibrium quickly.
How do we illustrate the fixed exchange rate case with the Phillips curve?
The long- and short-run Phillips curve diagram shows the relationship between the
inflation rate and unemployment. (We have drawn the short-run Phillips curves as
straight lines just for simplicity.) We start at a level of inflation of 5%. As inflation starts
to fall, the short-run Phillips relationship has expectations lagging behind actual
inflation and we move down the short-run Phillips curve. Unemployment increases
from the natural rate of unemployment to U2. When expectations have adjusted to
the new lower level of inflation, the short-run Phillips curve will shift in and we will
return to the natural rate of unemployment, but this may take time.
Inflation
rate
long-run
Phillips curve
5%
short-run Phillips curve:
high expected inflation
2%
short-run Phillips curve:
low expected inflation
natural rate of
unemployment
U2
Unemployment Rate
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Macroeconomic adjustment and EMU
6
Reflection
Yes
Partly
No
1. Do you understand why there is an adjustment
problem with a fixed exchange rate?
2. Do you understand the difference between the short
and long run in the Phillip’s diagram and how this
relates to equilibrium?
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.
Problem Focused Exercise: Macroeconomic adjustment and EMU
7
Notes for lecturers
Objectives of the exercise and prerequisites
Learning Focus: Understanding the real exchange rate as a macroeconomic
adjustment mechanism and how this would be affected by joining the euro;
identifying the model required for the analysis; understanding the importance if the
different equilibrating mechanisms under the two regimes.
Threshold Concepts pivotal to this learning are interactions between markets and
the use of expectations and equilibrium in economic modelling.
Prior Knowledge Required
Students need to have knowledge of a macroeconomic model that allows them to
connect export and import changes to aggregate demand. If they have covered
the AD/AS model, the feedback in section 1 relates to this (but this is on a separate
page in case of students who have not covered this model). To do the second
section students need to have covered the short-run and long-run Phillips curve.
Sequencing and timing
1.
Task 1 asks students to read quite a detailed extract from the Treasury and
obtain from the extract the answer to two questions. The task can be carried
out on an individual basis but students may benefit from working in groups.
Students can be asked to give a presentation of their findings to encourage
participation (this can be certain selected groups rather than all in order to fit
the time scheduling).
2.
Feedback for task 1 should be given before students attempt task 2. The
feedback should include the section on the application of the AD/AS model if
this has been covered in your module.
3.
Task 2 asks students look at an opposite shock to the system than that
considered in task 1. It requires students to be aware of the expectations
augmented Phillips curve.
4.
The complete exercise is likely to take 40 minutes, without any group
presentations.
Developed by the Embedding Threshold Concepts Project
10/09/08
This project is funded by the Higher Education Funding Council for England (HEFCE) and the Department for Employment
and Learning (DEL) under the Fund for the Development of Teaching and Learning.