Question 1

An expansionary fiscal policy according to Beardshaw (2001) is a set of government

measures designed or tailor-made to influence the direction of the macroeconomy through
increased government spending and a reduction in the level of taxation. An expansionary or
reflationary fiscal policy is designed to increase the level of economic activity through
increased employment, production and income (Sloman J, 2006). A fixed exchange rate
regime is a system of exchange rates where the price of the currency is set or fixed by the
government, which goes on to determine the rate for a long time. A natural rate of output
refers to the fixed level of output that a nation’s economy can produce in the long run given
the quantity of its resources in the form of land resources, labour, capital and the level of
technology ( Samuelson, 2019).

An expansionary fiscal policy is known to be most effective under the system of fixed
exchange rates as shown in the diagram below.

Price Level LRAS SRAS1

SRAS

Pc C

PA

PE E

AD1

AD

0 YN YA Income

Source: International Economics by Dominic Salvatore 11th Edition

The diagram above shows the impact of an expansionary fiscal policy from the natural rate of
output denoted by YN under fixed exchange rates. Starting from the long run equilibrium E,
which is the intersection of the aggregate demand AD and short-run aggregate supply SRAS,
an expansionary fiscal policy will result in an increase in aggregate demand from AD to AD 1.
The new equilibrium level of output will be defined at A which corresponds to the level of
output YA, which is greater than the initial output YN. As time lapses into the long run, the
short run aggregate supply shifts upwards from SRAS to SRAS 1, defining the new
equilibrium at point C which corresponds to the price level P C and output level YN. The price
is now higher, but the level of output is eliminated in the long run as expected prices rise to
match the increase in actual prices.

The temporary expansion of output to Y A occurs because of market imperfections as well as

information asymmetry in a case of a closed economy. This occurs because firms originally
believe that only the price of products they sell has increased and the actual prices
temporarily exceed anticipated prices. Over time, as firms realise that all prices including
production costs have also increased, the SRAS curve will shift up to SRAS1.

Dealing with an open economy, the openness of an economy has already been incorporated
into AD and AD1 curves, the process by which the nation’s output temporarily exceeds but
then returns to its long-term natural level at higher prices is exactly the same as in the closed
economy case.

Question 2

Dollarization, according to Madura (2009) involves a country adopting the currency of

another country as its own legal tender and commonly referred in reference to the adoption of
the United States dollar. For instance after a period of hyperinflation, Zimbabwe dollarized
its economy in 2009, though it was in conjunction with a basket of other currencies such as
the South African Rand and the Botswana Pula. Dollarization involves the complete
renouncement of the nation’s monetary sovereignty by giving up on the ‘exit option’ to
abandon its monetary system.

An optimum currency area or bloc refers to a group of nations whose national currencies are
linked through permanently fixed exchange rates (Shapiro A.C 2014). The currencies of
member states are then allowed to float with respect to the currencies of non-member
countries. An example of an optimum currency area is the European Monetary System which
created the European Currency unit, keeping the exchange rate of member states fluctuating
within a 2.25% band (Salvatore, 2013).
The benefits of dollarization arise from the avoidance of the cost of exchanging the domestic
currency for dollars and the need to hedge again foreign exchange risks, facing the rate of
inflation similar to that of the United States currency as a result of commodity arbitrage
(Salvatore, 2013). Shapiro A. C (2014) contends that a country dollarizing can also avoid
foreign exchange crises and the need for foreign exchange and trade controls as well as the
fostering of the budget discipline. In the same regard, Levi M.D (2009) opines that
dollarization encourages more rapid and full international financial integration.

The formation of an optimum currency area according to Salvatore (2013) eliminates the
uncertainty that arises when exchange rates are not permanently fixed, thus stimulating
specialisation in production and the flow of trade and investment among member countries.
Shapiro A.C (2013) argues that the formation of an optimum currency area also encourages
producers to view the entire area as a single market and to benefit from greater economies of
scale in production.

An optimum currency area also brings in price stability because the random shocks in
different regions or nations within the area tend to cancel each other out. The greater price
stability encourages the use of the currency as a store of value and as a medium of exchange,
and do away with the inconveniences of barter exchanges in inflationary circumstances. It
also saves the cost of official interventions in the foreign exchange markets involving the
currencies of member nations, the cost of hedging, and the cost of exchanging the currency
for another to pay for imports of goods and services.

Dollarization imposes costs on the economy such as the loss of the independence of monetary
and exchange rate policies as well as the costs of replacing the domestic currency with the
dollar (Salvatore, 2013). On the other hand the disadvantage of an optimum currency area is
that each member nation cannot pursue its own independent stabilisation and growth policies
attuned to its particular preferences and circumstances.

Question 3

Sloman (2006) defines a fiscal policy as a set of government measures which are
implemented to influence the direction of the macroeconomy through changes in government
spending and the level of taxation. A monetary policy, on the other hand, is a set of
government measures which are meant to influence the direction of the economy, through the
central bank, by influencing money supply and the level of interest rates (Lipsey, 1997). A
fixed exchange rate system is an exchange rate regime in which the external value of the
currency or the price of a currency in terms of other currencies is determined or fixed by the
government.

The combination of the fiscal to achieve internal balance and monetary policy to achieve
external balance with fixed exchange rates face several criticisms. The first critique states that
short term international flows of capital may not respond as expected to interest rate
differentials, and their response maybe inadequate or even erratic and a once-and-for-all
nature rather than continuous (Salvatore, 2013). The use of the monetary policy allows the
nation to finance its deficit in the short-run, unless the deficit nation continues to tighten its
monetary policy over time. The long run adjustment process may require exchange rates to
change rather than staying fixed over time.

Levi M.D (2009) claims that the government and monetary authorities do not know precisely
what effects of fiscal and monetary policies will be and there are various delays in
recognition, policy selection, and implementation before the policies begin to show effect.

It is also cumbersome to coordinate fiscal and monetary policies because the fiscal policy is
conducted by the central government, representing the political decisions adopted by the
government, whereas the monetary is the responsibility of the central banks.

However, a nation may still be able to move closer to internal and external balance on a step-
by-step basis. If fiscal policy authorities pursue only the objective of internal balance and
disregard the external imbalance, and if the monetary authorities can be persuaded to pursue
only the goal of external balance without regard to the effect that monetary policies have on
internal balance (Shapiro AC, 2014).

Question 4

The portfolio balance approach to the balance of payments according to Salvatore (2013) is a
theory that postulates that exchange rates are determined in the process of balancing the
demand and supply of financial assets in each country. The portfolio balance model assumes
that domestic and foreign bonds are imperfect substitutes because of the currency risk
associated with foreign assets as well as the possibility of higher default risk.

The monetary approach to the balance of payments and exchange rate determination
propounded by Robert Mundell and Harry Johnson in 1960 represents an extension of
domestic monetarism to international economy in that it views to the balance of payments as
an economy as an essentially monetary phenomenon. It states that money plays a crucial role
in the long run both as a disturbance and as an adjustment in the nation’s balance of
payments.

The theory is premised on the fact that money is viewed as merely one asset of many. The
exchange rate is the rate which equates the demand and supply for financial assets. The split
between money, domestic and foreign bonds depends upon wealth, relative rates of interest,
expected appreciation and depreciation of foreign currency and the risk premium. A change
in any of these factors will cause a portfolio re-allocation and the exchange rate will change
to the degree that foreign bond sale change.

The portfolio balance approach widens the monetary approach by including financial assets
such as bonds in it. The monetary approach assumes monetary factors impact the demand and
supply of money and determine the equilibrium exchange rates. While the portfolio balance
approach states that domestic assets and foreign assets are not perfect substitutes for each
other monetary approach assumes that domestic securities, which represent assets other than
money, are the perfect substitute for foreign assets. The monetary approach is a single asset
portfolio model whereas the portfolio balance model deals with multi-assets and integrates
the analysis of the exchange rate behaviour with other financial assets such as bonds and
stocks.

The portfolio balance model contains features provided by the monetary approach and the
balance of payments approach. Residents of the two countries hold the assets issued by these
two countries. Domestic residents wish to hold a greater proportion of their wealth in
domestic assets while foreign residents wish to hold a greater proportion in foreign assets.
Under the portfolio balance model, economic agents have to choose from a portfolio of
domestic and foreign assets. These assets are in the form of money and bonds, where money
has zero returns whilst bonds have positive expected returns, which create arbitrage
opportunities which in turn help to determine exchange rates among countries.
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