Due Date: Thursday, September 8th (at the beginning of class)



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Problem Set 5

FE312 Fall 2007

Rahman



Partial Ans Key



  1. Explain briefly (2 or 3 sentences) why a monetary contraction for a small open economy under fixed exchange rates will have no effect on real income.


A monetary contraction shifts the LM* curve to the left, putting downward pressure on the exchange rate. However, the central bank is committed to the original rate – people will then sell the central bank foreign currency and buy domestic currency. This will then INCREASE the money supply – in fact the money supply returns to precisely what it was before, and thus output does not get affected.


  1. If a small open economy with a flexible exchange rate is experiencing a recession, what will automatically happen over time to its trade balance, foreign exchange rate, and national output? Illustrate graphically.




Say that Y(LR) is the long run output for the economy, while Y1 is where the economy is right now. Then, what must happen is PRICES WILL FALL – this of course means that real money balances rise, implying a rightward shift in the LM* curve. Note that this also implies a decrease in the real exchange rate.

  1. The Mundell-Fleming model take the world interest rate r* as an exogenous variable. Let’s consider what happens when this variable changes.




    1. What might cause the world interest rate to rise?


World demand for investment could rise, or world savings could decline..


    1. In the Mundell-Fleming model with a floating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises?


Increase in the world interest rate should lower investment (I), and so the IS* curve should shift to the left. This lowers the nominal exchange and makes net exports rise, but aggregate income remains constant.


    1. In the Mundell-Fleming model with a fixed exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises?


Again, the IS* curve shifts left. Now, however, the LM* curve shifts left as well to keep the nominal exchange constant. Net exports thus remains unaffected, but now output decreases.


  1. Suppose the government in a small developing economy places restrictions on agricultural exports (say in order to increase the domestic food supply and lower food prices). Use the Mundell-Fleming model to analyze the short-run effects of this policy on the exchange rate and real GDP (illustrate using the graphs) if the country has a:




    1. flexible exchange rate


The IS* curve shifts to the left. Exchange rate falls, output remains the same.


    1. fixed exchange rate


Again, the IS* curve shifts to the left. LM* curve also shifts to the left such that the exchange rate remains unchanged. Output falls.



  1. Finally, use the Mundell-Fleming model to illustrate the short-run effects of the Mexican crises (discussed in the text, pgs 300-331) in a small open economy with a fixed exchange rate. What happens to output, and why?


See pages 353-355 of your text. In a nutshell, both the IS* and LM* curves shift to the left, and this lowers GDP.



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