PART B: IS-LM for an Open Economy Consider a small open economy, which is at the long-run equilibrium unless a question indicates otherwise. The small open economy is described by the following equations: CdIdNXMd/P=300+0.75(YT)300r=200200r=6000.2Y50e=0.5Y500i where Y is output, T is a lump sum tax, G is government spending, i is the nominal rate of interest, e is the real exchange rate, and P is the price level. i. Explain why there is a negative relationship between net export, NX, and the real exchange rate, e. ii. Derive an algebraic expression for the IS and LM curves with the real rate of interest, r, on the left-hand side of the equation. iii. Assume the nominal money supply, M, is 2400 , the price level of the domestic economy, P, is 2 , the price level of the rest of the world, Pw, is 2, inflation expectation, e, is 5%, real output, Y, is 2500 , government spending, G, is 600 , and the government budget is balanced. a) Find the real interest rate, r. b) Find both the real and nominal exchange rates. c) Find net exports, NX. Is the domestic country borrowing or lending? iv. Assume this economy has a flexible exchange rate regime. The central bank decides to increase the nominal money supply to 2550 . a) Find the level of output and the real exchange rate in the short run. b) Find the short run levels of desired consumption, desired investment, and net exports. Using government spending from part iii. show that they add up to the short-run output. c) Using the open economy IS/LM/FE model graph, show the initial equilibrium, the short run (SR) equilibrium and the return to the long run (LR) equilibrium. v. In part iv., instead of a flexible exchange rate regime, assume a fixed exchange rate regime. Explain and show using the open economy IS/LM/FE graph what would happened to the economy. Assume the government does not use its fiscal policy tools. vi. Instead of a monetary policy expansion, now suppose the government decides to increase spending to 700 while maintaining a balanced budget. The economy is following a fixed exchange rate regime. 4 a) Find the level of output in the short run. b) Find by how much the central bank had to change its nominal money supply to keep the nominal exchange rate constant in the short run. c) Find the real money supply in the long run. d) Finally, find net export (NX) and compare to your answer from part iii. PART B: IS-LM for an Open Economy Consider a small open economy, which is at the long-run equilibrium unless a question indicates otherwise. The small open economy is described by the following equations: CdIdNXMd/P=300+0.75(YT)300r=200200r=6000.2Y50e=0.5Y500i where Y is output, T is a lump sum tax, G is government spending, i is the nominal rate of interest, e is the real exchange rate, and P is the price level. i. Explain why there is a negative relationship between net export, NX, and the real exchange rate, e. ii. Derive an algebraic expression for the IS and LM curves with the real rate of interest, r, on the left-hand side of the equation. iii. Assume the nominal money supply, M, is 2400 , the price level of the domestic economy, P, is 2 , the price level of the rest of the world, Pw, is 2, inflation expectation, e, is 5%, real output, Y, is 2500 , government spending, G, is 600 , and the government budget is balanced. a) Find the real interest rate, r. b) Find both the real and nominal exchange rates. c) Find net exports, NX. Is the domestic country borrowing or lending? iv. Assume this economy has a flexible exchange rate regime. The central bank decides to increase the nominal money supply to 2550 . a) Find the level of output and the real exchange rate in the short run. b) Find the short run levels of desired consumption, desired investment, and net exports. Using government spending from part iii. show that they add up to the short-run output. c) Using the open economy IS/LM/FE model graph, show the initial equilibrium, the short run (SR) equilibrium and the return to the long run (LR) equilibrium. v. In part iv., instead of a flexible exchange rate regime, assume a fixed exchange rate regime. Explain and show using the open economy IS/LM/FE graph what would happened to the economy. Assume the government does not use its fiscal policy tools. vi. Instead of a monetary policy expansion, now suppose the government decides to increase spending to 700 while maintaining a balanced budget. The economy is following a fixed exchange rate regime. 4 a) Find the level of output in the short run. b) Find by how much the central bank had to change its nominal money supply to keep the nominal exchange rate constant in the short run. c) Find the real money supply in the long run. d) Finally, find net export (NX) and compare to your answer from part
