1.Assume the exchange rate is allowed to fluctuate freely.Using the IS-LM-IP model, graphically illustrate and explain what effect monetary contraction will have on the domestic economy.In your graphs, clearly label all curves and equilibria.

2.Assume the exchange rate is allowed to fluctuate freely.Using the IS-LM-IP model, graphically illustrate and explain what effect a reduction in foreign output (Y*) will have on the domestic economy.In your graphs, clearly label all curves and equilibria.

3.Assume the exchange rate is fixed.Using the IS-LM model, graphically illustrate and explain what effect a reduction in consumer confidence will have on the domestic economy.In your graphs, clearly label all curves and equilibria.

4.In this chapter, we showed that a monetary expansion in an economy operating under flexible exchange rates leads to an increase in output and a depreciation of the domestic currency.

a.How does a monetary expansion (in an economy with flexible exchange rates) affect consumption and investment?

b.How does a monetary expansion (in an economy with flexible exchange rates) affect net exports?

5.Consider an open economy with flexible exchange rates. Suppose output is at the natural level, but there is a trade deficit. What is the appropriate scal-monetary policy mix?

6.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 scal policy in this chapter, what effect is a foreign scal 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 scal expansion affect domestic output? How does a foreign monetary expansion affect domestic output? (Hint: one of these policies has an ambiguous effect on output.)

7.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 characterized 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 scal coordination, such as the common increase in G and G* in part (d), difficult to achieve in practice?