Question

For questions 1 through 9, suppose the structure of an economy with a flexible exchange rates is represented by the following equations: C = 400 + 0.85*(Y – T) L(r, Y) = 0.25*Y – 25*r T = 200 MS /P = 2250 I = 1700 – 25*r G = 1800 NX = 900 – 200*e where e represents the real exchange rate

1. Intuitively, the real exchange rate affects net exports (NX)

(a) negatively because real depreciations (e↓) make domestic goods less competitive

(b) negatively because real appreciations (e↑) have negative impacts on NX

(c) positively because real appreciations (e↑) have positive impacts on NX

(d) positively because real appreciations (e↑) make domestic goods more valuable

2. The equation for the IS curve is [HINT: Recall that the equilibrium in the goods market in open economy is Y = C + I + G + NX; solve for Y as a function of r and e]

(a) Y = [4630 – 25*r – 200*e]/0.15

(b) Y = 4430 – 25*r – 200*e

(c) Y = [4430 – 25*r – 200*e]/0.15

(d) Y = 4400 – 25*r – 200*e

3. The equation for the LM curve is [HINT: Recall that the equilibrium in the financial market is given by MS /P = L(r,Y); solve for Y as a function of r; no change here with respect to the closed-economy case]

(a) Y = 9000 – 100*r

(b) Y = 0.01*r – 90

(c) Y = 0.01*r + 90

(d) Y = 9000 + 100*r

When there is perfect capital mobility, the equilibrium in international capital markets implies that interest rates here and abroad must be equal; otherwise capital would continuously flow towards more profitable markets. That is, r = rf Assume that this is a small open economy so that it cannot control the foreign interest rate (rf ). That is, the interest rate is exogenous (i.e., determined outside the model). Notice that in this case, the equilibrium in the financial market (LM curve) is enough to determine equilibrium Y. 2

4. The equilibrium output (Y) for this economy if rf = 2 is

(a) 9200

(b) 9600

(c) 90.02

(d) 8800

5. Equilibrium consumption (C) is [HINT: Use the Y you found in question 4]

(a) 7710

(b) 7820

(c) 7850

(d) 8050

Answer 1

1.

The relationship between net export and the interest rate is negative. This is because, as real exchange rate rises, the currency appreciates, imports become cheaper and export expensive (because the foreigners have to give more per unit of domestic currency and this perceived as expensive imports). As imports become cheaper import rises and export falls on the other hand. This decreases net export. Then the relationship between net export and exchange rate is negative.

The correct option is (b)