Question

A small open economy is described by the following equations: C = 50 + .75(Y - T)
I = 200 - 20i
NX = 200 - 50E
M/P = Y - 40i
G = 200
T = 200
M = 3000
P=3

i* = 5

b. Assume a floating exchange rate and constant expectations. Calculate what happens to the exchange rate, the level of income, net exports, and the money supply if the government increases its spending by 50. Use a graph to explain what your findings. (5 points)

c. How does the equilibrium in (b) change if financial agents’ expectations change? (5 points)

d. Now, suppose that money demand depends on disposable income, so that the equation for the money market becomes M /P = L (i, Y -T). Analyze the short-run impact of a tax cut in a small open economy on the exchange rate and income under floating exchange rates. (5 points)

e. Now assume a fixed exchange rate. Calculate what happens to the exchange rate, the level of income, net exports, and the money supply if the government increases its spending by 50. Use a graph to explain what you find. (5 points)

f. The Mundell-Fleming model take the world interest rate i* as an exogenous variable. Let’s consider what happens when this variable changes. Which causes might drive the world interest rate up? (5 points).

g. Assume that the world interest rate rises. What happens in the foreign exchange market and the money market, under a fixed exchange rate? Show graphically effects to aggregate income, the exchange rate, and the trade balance, and give a brief explanation. (5 points)

h. Under a fixed exchange rate, how can authorities control the trade balance? (5 points)

Answer 1

b. If government increases it's spending by 50 then there will be a decrease in the exchange rate, increase in the level of income and in the net exports.

c. The equilibrium in (b) changes if the financial agents expectations change because the level of income increases with a decrease in the exchange rate.

d. If the money demand depends on the disposable income then the short run impact on of a tax cut in a small open economy on the exchange rate will decrease and income under floating exchange rate will also decrease.

e. In a fixed exchange rate if the government increases it's spending by 50 then the exchange rate will also change, level of income increases with a fixed rate, the net exports will decrease with a decrease in the money supply.