978-0078021770 Chapter 23 Solution Manual

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 eort 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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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 aecting

domestic product and income in the short run. For instance,

expansionary .scal policy tends to increase domestic product, but the

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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= (PFxX )– (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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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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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

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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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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

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forwarded, distributed, or posted on a website, in whole or part.

Interest

rate = i

Yfull Y0 Domesc

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

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forwarded, distributed, or posted on a website, in whole or part.

Interest

rate = i

Yfull Y Y0 Domesc′

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 = PfcxX PfcmM.

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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forwarded, distributed, or posted on a website, in whole or part.