Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: daixieit


Intermediate Economics B

Problem Set 5

1. Flexible exchange rates and foreign macroeconomic policy.  Consider an open economy with flexible exchange rates. Let UIP stand for the uncovered interest parity condition.

(a) In an IS–LM–UIP diagram, show the effect of an increase in foreign output,

Y* , on domestic output, Y . Explain in words.

(b) In an IS–LM–UIP diagram, show the effect of an increase in the foreign interest

rate, i* , on domestic output, Y . Explain in words.

(c)  Given the discussion of the effects of fiscal policy in this chapter, what effect is a foreign fiscal expansion likely to have on foreign output, Y* , and on the foreign interest rate, i* ? Given the discussion of the effects of monetary policy in this chapter, what effect is a foreign monetary expansion likely to have on Y*  and i* ?

(d)  Given your answers to parts (a), (b), and (c), how does a foreign fiscal expan- sion affect domestic output?  How does a foreign monetary expansion affect domestic output?   (Hint:  one of these policies has an ambiguous effect on output.)

2. Policy coordination and the world economy.  Consider an open economy in which the real exchange rate is fixed and equal to one.  Consumption, investment, government spending, and taxes are given by

C = 10 + 0.8(Y − T), I = 10, G = 10 and T = 10

Imports and exports are given by

IM = 0.3Y and X = 0.3Y*

where Y*  denotes foreign output.

(a)  Solve for equilibrium output in the domestic economy, given Y* . What is the

multiplier in this economy? If we were to close the economy – so exports and imports were identically equal to zero – what would the multiplier be?  Why would the multiplier be different in a closed economy?

(b) Assume that the foreign economy is characterised by the same equations as

the domestic economy (with asterisks reversed). Use the two sets of equations to solve for the equilibrium output of each country.  [Hint:  use the equations for the foreign economy to solve for Y*  as a function of Y and substitute this solution for Y* in part (a).] What is the multiplier for each country now? Why is it different from the open economy multiplier in part (a)?

(c) Assume that the domestic government, G, has a target level of output of 125. Assuming that the foreign government does not change G* , what is the increase in G necessary to achieve the target output in the domestic economy?  Solve for net exports and the budget deficit in each country.

(d)  Suppose each government has a target level of output of 125 and that each government increases government spending by the same amount. What is the common increase in G and G*  necessary to achieve the target output in both countries? Solve for net exports and the budget deficit in each country.

(e) Why is fiscal coordination, such as the common increase in G and G*  in part

(d), difficult to achieve in practice?

3. The exchange  rate  as  an  automatic  stabiliser.   Consider an economy that suffers a fall in business confidence (which tends to reduce investment).  Let UIP stand for the uncovered interest parity condition.

(a)  Suppose the economy has a flexible exchange rate. In an IS–LM–UIP diagram,

show the short-run effect of the fall in business confidence on output,  the interest rate and the exchange rate.   How does the change in the exchange rate, by itself, tend to affect output?  Does the change in the exchange rate dampen (make smaller) or amplify (make larger) the effect of the fall in business confidence on output?

(b)  Suppose instead the economy has a fixed exchange rate.  In an IS–LM–UIP

diagram, show how the economy responds to the fall in business confidence. What must happen to the money supply in order to maintain the fixed exchange rate? How does the effect on output in this economy, with fixed exchange rates,

compare to the effect you found for the economy in part  (a), with flexible exchange rates?

(c) Explain how the exchange rate acts as an automatic stabiliser in an economy with flexible exchange rates.