13. [16 marks = 4 + 4 + 4 + 4] Suppose the economy was initially at the long-run equilibrium. The consumption in the country depends on the disposable income, Y-T, C = C(Y-T) and the investment depends on the interest rate of the country, i, I=1(i). The applicable IS-LM- FX model is pictured here: Expected return LMI il DR IS1 FRI EHF Assume the home country follows a floating exchange rate system. Now, there is a decrease in the foreign interest rate i* (a) Assume the home country follows a floating exchange rate system. Use the IS-LM-FX model (redraw the diagrams above again in your answer book) to illustrate the short-run effects of a decrease in the foreign interest rate, EHF, and explain what shifts which curve(s). On the graphs, label the initial equilibrium point A, and the new equilibrium point B. Be sure to label all IS and LM curves and equilibrium levels of Y, i, and EHF to get full marks. (4 marks) (b) In the situation of (a), use the goods market equilibrium equation and the three elements that determine the trade balance to explain the impact of the policy on (i) the trade balance of the home country, and (ii) today's exchange rate (increaseo-change/fall) compared to the initial level. (4 marks) 13. [16 marks = 4 + 4 + 4 + 4] Suppose the economy was initially at the long-run equilibrium. The consumption in the country depends on the disposable income, Y-T, C = C(Y-T) and the investment depends on the interest rate of the country, i, I=1(i). The applicable IS-LM- FX model is pictured here: Expected return LMI il DR IS1 FRI EHF Assume the home country follows a floating exchange rate system. Now, there is a decrease in the foreign interest rate i* (a) Assume the home country follows a floating exchange rate system. Use the IS-LM-FX model (redraw the diagrams above again in your answer book) to illustrate the short-run effects of a decrease in the foreign interest rate, EHF, and explain what shifts which curve(s). On the graphs, label the initial equilibrium point A, and the new equilibrium point B. Be sure to label all IS and LM curves and equilibrium levels of Y, i, and EHF to get full marks. (4 marks) (b) In the situation of (a), use the goods market equilibrium equation and the three elements that determine the trade balance to explain the impact of the policy on (i) the trade balance of the home country, and (ii) today's exchange rate (increaseo-change/fall) compared to the initial level. (4 marks)
