Macroeconomics. A fixed exchange rate - Essay Example

5. Using the closed economy IS-LM model, show how falls in business and consumer confidence can precipitate a deep and prolonged recession. Set out what Keynes meant when he advocated fiscal policy to solve the problem. 10 6. By what means may the monetary authorities maintain a fixed exchange rate Outline how devaluation may help a country experiencing difficulties under a fixed exchange rate regime and set out circumstances under which devaluation makes things worse. 13 The Keynes and Pigou effects can be understood in the context of the impact of a change in the money supply on consumption.

The economists Keynes and Pigou studied the effects of a fall in wages and prices on real aggregate demand and attempted to determine what underlies the closed-economy AD curve. Keynes maintained that a fall in money wages and price levels would reduce the demand for money and result in a fall in interest rates, thereby taking the economy to full employment. This is known as the Keynes effect. This takes place, he explained, in a situation where the money supply is constant because a fall in price levels would increase the real money supply. . rence between money supply and real money supply We define the money supply as the quantity of money supplied by the central bank and then assume that it is constant or unchanged for different price levels.

However, if the money supply (represented by the variable M) is constant while the price level (P) falls, the real money supply (represented by the fraction M/P) increases. Therefore, a fall in P at constant M raises M/P, the real money supply that in effect represents the "value" of M, shifting the upward sloping L-M curve to the right, with effects that are analogous to those of an increase in M.Increasing M has the effect of bringing the interest rate down, generating a rise in investment spending.

Businesses will expand to increase production, employment will rise, and so would output and consumption. The effect would be small (that is, the AD curve is steep) if either (a) the L-M curve is quite flat so that the fall in the interest rate is small, or (b) the downward sloping I-S curve is steep, so that falls in interest rate will have little effect on spending. In standard textbooks, the derivation of the closed economy aggregate demand (AD) curve relies entirely on the Keynes effect.

Pigou studied the same phenomenon and maintained that lower prices would encourage consumption, thereby boosting total income and employment. This is known as the Pigou effect. Like Keynes, he observed that a fall in prices would raise the real money supply (M/P), which raises wealth and stimulates a rise in consumption. This shifts the I-S curve to the right. The Pigou effect is largest when the Keynes effect is smallest (that is, the L-M curve flat and the I-S curve steep). This phenomenon, also known as the real balance effect, is based on the assumption that part of