Answer to Question #283422 in Macroeconomics for Comfort

Question

QUESTION NINETEN

Suppose the income levels of our small country, Zambia suddenly increases fromY1 to Y2, use the

monetary approach to explain this change adequately. If on the other hand, we assume that Zambia

uses a pegged exchange rate, show using the monetary approach how such a sudden upswing in income

would affect the BOP and the economy at large. If you feel that there is need to illustrate the scenario

above graphically, you can draw a well-labelled graph. [15 marks]

Answer 1

The monetary approach is concerned with the relationship between the domestic component of the money stock (or, the monetary base), prices, output, and interest rates and the balance of payments. The monetary approach assumes that the country is small as Zambia and that the country operates a fixed or pegged exchange rate regime, and that there is perfect international mobility of goods and financial assets which means that domestic prices and interest rates will be equal to their respective world values and will be determined exogenously.

The increase in income levels from Y1 to Y2 means that the money supply in the economy increases. The excess money supply means that there is loss of Zambia's international reserves affecting the BOP. The interest rate will go low due to excess money supply which will also lead to increase in prices thus leading to inflation. Overall, the economic growth of the country will be affected negatively and will start to deteriorate.