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The final result is that income does not change, and the exchange rate appreciates
from e1to e2. Net exports fall because of the appreciation of the currency.
Thus, our answer is the same as that given in Table 12–1.
b. Figure 12–21 shows the effect of a fiscal expansion under fixed exchange rates.
6. We want to consider the effects of a tax cut when the LM*curve depends on disposable
income instead of income:
M/P = L[r, Y– T].
132 Answers to Textbook Questions and Problems
A tax cut now shifts both the IS*and the LM*curves. Figure 12–22 shows the
case of floating exchange rates. The IS*curve shifts to the right, from IS*
1to IS*
2. The
LM*curve shifts to the left, however, from LM*
1to LM*
2.
We know that real balances M/P are fixed in the short run, while the interest rate
is fixed at the level of the world interest rate r*. Disposable income is the only variable
that can adjust to bring the money market into equilibrium: hence, the LM*equation
determines the level of disposable income. If taxes Tfall, then income Ymust also fall
to keep disposable income fixed.
In Figure 12–22, we move from an original equilibrium at point A to a new equi-
librium at point B. Income falls by the amount of the tax cut, and the exchange rate
appreciates.
Chapter 12 Aggregate Demand in the Open Economy 133
e
e
Exchange rate
A
B
LM1LM2
**
e
Figure 12–23
e
B
e2
LM2LM1
**
Figure 12–22
7. Since people demand money balances in order to buy goods and services, it makes sense
to think that the price level that is relevant is the price level of the goods and services
they buy. This includes both domestic and foreign goods. But the dollar price of foreign
goods depends on the exchange rate. For example, if the dollar rises from 100
yen/dollar to 150 yen/dollar, then a Japanese good that costs 300 yen falls in price from
$3 to $2. Hence, we can write the condition for equilibrium in the money market as
M/P = L(r, Y),
where
P= λPd+ (1 – λ)Pf/e.
a. A higher exchange rate makes foreign goods cheaper. To the extent that people
consume foreign goods (a fraction 1 – λ), this lowers the price level Pthat is rele-
134 Answers to Textbook Questions and Problems
Chapter 12 Aggregate Demand in the Open Economy 135
c. The increase in the risk premium raises the interest rate for this country, lower-
ing money demand at any given exchange rate and thereby shifting the LM* curve
to the right. Intuitively, if real-money balances are fixed, then real-money demand
must remain fixed. The decline in money demand caused by the increase in the
interest rate must be offset by an increase in money demand caused by an
If money demand is not very sensitive to the interest rate and investment is very
sensitive to the interest rate, then IS* will shift by more than LM* and output will
decline. Compared to the traditional Mundell-Fleming model, where LM* is verti-
cal, output can fall here, whereas it does not fall in the traditional model but
instead always rises. This model gives the more realistic result that both the
exchange rate and output are likely to decline when the risk premium rises.
8. a. California is a small open economy, and we assume that it can print dollar bills.
Its exchange rate, however, is fixed with the rest of the United States: one dollar
can be exchanged for one dollar.
b. In the Mundell–Fleming model with fixed exchange rates, California cannot use
monetary policy to affect output, because this policy is already used to control the
exchange rate. Hence, if California wishes to stimulate employment, it should use
B
Y
Income, output
IS2
*
IS1
*
Y1
136 Answers to Textbook Questions and Problems
A. The Mundell-Fleming Model
B. The Model of Aggregate Supply and Aggregate Demand
∋
C
P
P2
C
LM*
Figure 12–26
More Problems and Applications to Chapter 12
1. a. Higher taxes shift the IS curve inward. To keep output unchanged, the central
bank must increase the money supply, shifting the LM curve to the right. At the
new equilibrium (point C in Figure 12–27), the interest rate is lower, the exchange
rate has depreciated, and the trade balance has risen.
Chapter 12 Aggregate Demand in the Open Economy 137
A. The IS–LM Model B. Net Capital Outflow
LM1
LM2
rr
C. The Market for Foreign Exchange
CF
e
Figure 12–27
b. Restricting the import of foreign cars shifts the NX(e) schedule outward [see panel
(C)]. This has no effect on either the IS curve or the LM curve, however, because
138 Answers to Textbook Questions and Problems
A. The IS-LM Model B. Net Capital Outflow
LM
IS
CF(r)
Income, output YCF
Real interest rate
rr
Net capital outflow
Figure 12–28
2. a. The CF curve becomes flatter, because a small change in the interest rate now has
a larger effect on capital flows.
b. As argued in the text, a flatter CF curve makes the IS curve flatter, as well.
d. It is clear from Figure 12–29 that the flatter the IS curve is, the greater effect any
change in the money supply has on output. Hence, the Fed has more control over
output.
Chapter 12 Aggregate Demand in the Open Economy 139
LM1
LM2
r
Figure 12–29
3. a. No. It is impossible to raise investment without affecting income or the exchange
rate just by using monetary and fiscal policies. Investment can only be increased
through a lower interest rate. Regardless of what policy is used to lower the inter-
est rate (e.g., expansionary monetary policy and contractionary fiscal policy), net
foreign investment will increase, lowering the exchange rate.
shows this combination of policies.
140 Answers to Textbook Questions and Problems
LM1
NX
Net exports
r
r
LM2
r1
CF CF
A
A
Figure 12–30
Chapter 12 Aggregate Demand in the Open Economy 141
c. Yes. Policymakers can raise investment without affecting income or the exchange
rate through a home monetary expansion and fiscal contraction, combined with a
lower foreign interest rate either through a foreign monetary expansion or fiscal
4. a. Figure 12–32 shows the effect of a fiscal contraction on a large open economy with
a fixed exchange rate. The fiscal contraction shifts the IS curve to the left in panel
LM1
r
r
LM2
r1
Figure 12–31
(A), which puts downward pressure on the interest rate. This tends to increase net
capital outflow and cause the exchange rate to depreciate [see panels (B) and (C)].
142 Answers to Textbook Questions and Problems
Income, output Y
CF
CF
IS2
IS1
Exchange rate
e
Net capital outflow
C. The Market for Foreign Exchange
CF
b. A monetary expansion tends to shift the LM curve to the right, lowering the inter-
est rate [panel (A) in Figure 12–33]. This tends to increase net capital outflow and
Chapter 12 Aggregate Demand in the Open Economy 143
A. The IS-LM Model
LM1
LM2
r
B. Net Capital Outflow
r
Figure 12–33
