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Suggested answer to case study discussion question
A Tale of Three Countries: (a) If Germany had raised taxes in 1991, then
the story probably would have turned out better. If Germany raised taxes,
then more of the eort to restrain the excessive growth and overheating of
the German economy would have been driven by a shift to the left of
Germany’s IS curve (from IS2 back toward IS1), so less of the restraint would
have come from the tightening of German monetary policy(Germany’s new
LM3 would be to the right of the LM3 shown in the box). German interest rates
would not have risen so much (maybe not at all). There would have been less
(or no) pressure on France and Britain to tighten their monetary policies to
try to match rising German interest rates. (b) If, instead, France had reduced
taxes in 1991, the story also probably would have turned out better (at least
for France). France could have used the assignment rule. Direct monetary
policy to achieve external balance—in this case, the French LM curve would
still shift toward the left as German interest rates increased. Direct .scal
policy to address internal balance, which in this case required expansion of
aggregate demand and real GDP. With a tax cut, France’s IS curve would shift
to the right from IS1. The decline in France’s GDP could have been resisted
and possibly prevented.
Suggested answers to end of chapter questions and problems
1. Disagree. The risk is rising unemployment, not rising in2ation. The
de.cit in its overall international payments puts downward pressure on
the exchange-rate value of the country’s currency. The central bank
2. The increase in government spending affects both the current account and the financial
account of the country's balance of payments. The increase in government spending
increases aggregate demand, production, and income. The increase in income and
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forwarded, distributed, or posted on a website, in whole or part.
3. Perfect capital mobility essentially eliminates the country’s ability to
run an independent monetary policy. The country must direct its
monetary policy to keeping its interest rate in line with foreign
Perfect capital mobility makes .scal policy powerful in aecting
domestic product and income in the short run. For instance,
expansionary .scal policy tends to increase domestic product, but the
181
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
4. The assignment rule says that a country with a fixed exchange rate can pursue both
external balance and internal balance by assigning fiscal policy the task of achieving
internal balance and assigning monetary policy the task of achieving external balance.
The possible advantages of the assignment rule include: (1) it provides clear guidance to
5. Agree. Consider the value of the country’s current account measured in
foreign currency (superscript F ):
CAF= (PFxX )– (PFm M )
6. a. Pugelovian holdings of official international reserves decrease by $10 billion, a decline in
b. The Pugelovian central bank is also buying pnuts in the intervention, so the Pugelovian
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authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
c. The Pugelovian money supply does not change (or does not decrease as much) if the
7. a. The FE curve shifts to the right or down.
b. The capital in2ows drive the country’s overall international payments
c. As the central bank intervenes by selling domestic currency in the
foreign exchange market, the country’s monetary base and its money
supply increase. The increase in the money supply lowers domestic
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authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
8. a. If the country's financial account is always zero, then the country's interest rates have no
direct effect on the country's balance of payments. The FE curve is a vertical line. (The
b. The increase in foreign demand for the country’s exports shifts the IS curve to the right to
IS' in the accompanying graph. The shock increases demand for the country's products, so
184
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authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
c. The rightward shift of the IS curve results in a new IS'-LM intersection with some
increase in the level of domestic product. The increase in domestic product and income
d. Assuming that the intervention is not sterilized, the intervention increases the country's
money supply. The LM curve shifts to the right (or down). The country returns to external
balance at the triple intersection E" when the LM curve has shifted to LM'. The country's
9. The country initially has an overall payment de.cit. In the IS-LM-FE
graph below, the IS-LM intersection at point A is to right of the FE curve.
(The FE curve is steeper than the LM curve because international
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authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
Is there anything that the central bank can do to avoid (or to minimize)
the loss of international reserves? The central bank could take a
domestic action to shift the LM curve more quickly to the left. For
10. a. Sterilized intervention would allow the situation to continue for a while, but it would not
address the initial macroeconomic situation in the sense of resolving it. The initial
macroeconomic situation is shown in the graph. The country’s initial IS0 curve intersects
186
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authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
Interest
rate = i
Yfull Y0 Domesc
product = Y
LM0
FE0
IS0
E
b. The country can use a change in the fixed exchange rate value to address the international
payments surplus. The country should revalue its currency (increase the exchange rate
value of the currency). The revaluation will reduce the country’s international price
187
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not
authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
Interest
rate = i
Yfull Y Y0 Domesc′
product = Y
LM0
FE′
11. a. Tighten .scal policy to address the internal imbalance of rising in2ation
b. Tighten .scal policy to address the internal imbalance of rising in2ation
c. Loosen .scal policy to address the internal imbalance of low demand
12. a. The value of the Pugelovian current account, measured in foreign currency units, is:
CA = PfcxX PfcmM.
If there is no change in quantities demanded (X and M are unchanged), then export and
import markets must clear at the same supply prices. Pugelovian exporters receive the
b. If Pugelovian firms keep the pnut prices of their exports the same, then the devaluation
results in a decrease in the foreign-currency price of Pugelovian exports (Pfcx). Generally,
foreign buyers will buy a larger quantity of Pugelovian exports (X increases). If foreign
firms keep the foreign-currency prices of their exports (Pfcm) the same, then the
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authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated,
forwarded, distributed, or posted on a website, in whole or part.
