2. This question uses a numerical example to understand the connections between the
goods, money, and foreign exchange (FX) markets. Use the information in the table
below to answer the questions that follow.
Goods Market
Money Market
FX Market
C = 300 + 0.8(Y − T) T = 400
M = 1050
Ee = 2
I = 400 − 2,000i (πe = 0)
L = 0.5Y − 5,000i
i* = 8%
G = 500
P = 2
TB = 400(1 − 2/E) − 0.2(Y − 100)
a. Find the MPC, MPCF, MPCH, and MPS for this economy.
b. Using the uncovered interest parity condition, solve for the exchange rate (E) as a
function of the home interest rate (i).
Answer: UIP condition:
c. Write out an expression for the IS and LM curves. You should have output (Y)
expressed as a function of the interest rate (i).
Answer: IS: Y = C + I + G + TB
Y = 2,330 − 6,000i
LM: M/P = L(i, Y)
d. Find the equilibrium (home) interest rate, i, and the equilibrium (home) output, Y.
Calculate consumption, investment, trade balance, and exchange rate at the
economy’s equilibrium.
Answer: We can find the equilibrium at the intersection of the IS‒LM curves:
To find the other equilibrium values, use the expressions given in the question:
To find the exchange rate, note from UIP:
E = 2/(0.92 + i) = 2/(0.92 + 0.08) = 2
e. Suppose the government wants to achieve a balanced budget through adjusting
taxes. What level of taxes would balance the budget? Repeat (a) and (d) using this
new level of taxes, assuming a floating exchange rate regime.
Answer: If T = 500, then G = 500 = T. The new IS curve is
To find equilibrium output, we can plug this value into either the IS or LM curve:
IS: Y = 2,130 − 6,000(0.0675) = 1,725
To find the other equilibrium values, use the expressions given in the question:
To find the exchange rate, note from UIP:
f. Using the IS‒LM‒FX model, illustrate how this change in taxes affects the
economy. Comparing the numerical values you found in (e) with those from (d),
are your answers consistent with the diagram?
Answer: See the following diagram. Yes, the changes noted previously are
g. Now, suppose that monetary policy is implemented to stabilize output. Find the
new level of money supply that will allow the economy to maintain the same level
of output with increased taxes. Calculate the new values for Y, i, E, C, I, and TB.
Answer: To determine the value of M that will return the economy to Y = 1,850,
we need to find which interest rate along the new IS curve will support this value
of output. From the new IS curve:
Plugging Y = 1,850 and I = 4.67% into the LM curve expression will reveal which
value of M will support this combination of output and interest rate along the new
IS curve:
LM: M/P = L(i, Y)
Therefore, the new LM curve is
Checking that the new equilibrium is where IS and LM intersect at Y = 1,850 and
I = 4.67%:
Substituting this interest rate into the IS or LM curve gives
Now we can calculate the new equilibrium values of consumption, investment,
the exchange rate, and the trade balance.
To find the exchange rate, note from UIP:
h. Using the IS‒LM‒FX model, illustrate how the combination of the tax increase
and monetary stabilization policy affects the economy. Comparing the numerical
values you found in (g) with those from (d), are your answers consistent with the
diagram?
Answer: See the following diagram. Yes, the changes noted previously are
j
3. Suppose that American consumers become less optimistic about economic conditions
and reduce their total consumption (for a given level of disposable income).
a. How will this affect consumption, investment, output, interest rates, and the trade
balance?
b. Describe briefly how your previous answers depend on the following:
(i) Marginal propensity to consume
(ii) Marginal propensity to consume foreign goods and services
(iii)Sensitivity of investment to changes in interest rates
Answer: Marginal propensity to consume: As the MPC increases, consumption
becomes more sensitive to changes in income (output), implying that a given
4. For each of the following situations, use the IS‒LM‒FX model to illustrate the effects
of the shock. For each case, state the effect of the shock (increase, decrease, no
change, or ambiguous) on the following variables: Y, i, E, C, I, TB. Assume the
government allows the exchange rate to float. See the following diagrams.
a. Lump–sum taxes increase.
b. Foreign income increases.
c. Investors expect an appreciation of the home currency.
d. The money supply decreases.
5. Suppose the Japanese government is considering two policies. One policy would
involve increasing government spending and the other would involve an expansion in
the money supply. How would each of these Japanese policies affect its own output
and its exchange rate with South Korea (E defined as won per yen)? Which of these
two policies would you expect South Korean exporters prefer? Explain.
Answer: A fiscal expansion will lead to an appreciation in the Japanese yen and a
6. For each of the following situations, use the IS‒LM‒FX model to illustrate the effects
of the shock. For each case, state the effect of the shock (increase, decrease, no
change, or ambiguous) on the following variables: Y, i, E, C, I, TB. Assume the
government responds by using monetary policy to stabilize output. See the following
diagrams.
a. Lump–sum taxes increase.
b. Foreign income increases.
c. Investors expect an appreciation of the home currency.
d. The money supply decreases.
7. Repeat the previous question, assuming the government responds to maintain a fixed
exchange rate. In which case or cases will the government response be the same as in
the previous question?
8. During the 1990s, American depositors dramatically increased the share of their funds
in money market mutual fund accounts. Although these accounts have restrictions
(such as limited access to funds and minimum deposit requirements), they offer
depositors higher interest rates versus standard checking. The widespread use of
financial instruments during the 1990s led to a decrease in money demand because
people held a smaller share of their deposits in checkable accounts (demand deposits).
a. How would this shock affect the U.S. output, interest rate, exchange rate,
consumption, investment, and trade balance?
Answer: A decrease in money demand leads to a rightward shift in the LM curve
b. How would your answer to (a) change if the Fed used monetary policy to stabilize
output?
c. How would your answer to (a) change if the Fed used monetary policy to
maintain a fixed exchange rate?
9. For each of the following scenarios, assume the economy experiences an exogenous
decrease in investment demand. For each case, illustrate the IS‒LM‒FX diagram and
state the effect of the shock (increase, decrease, no change, or ambiguous) on the
following variables: Y, i, E, C, I, TB. Here, we assume the policy makers’ objective is
to keep output fixed at its initial value.
a. Monetary policy response under a floating exchange rate regime
b. Fiscal policy response under a floating exchange rate regime
c. Monetary policy response under a fixed exchange rate regime
d. Fiscal policy response under a fixed exchange rate regime
e. Suppose that investors expect the central bank to respond to the shock and that the
economy has a floating exchange rate regime. How would this affect their
expectations about the exchange rate following the shock? How will they
respond? In other words, how will they shift their portfolio between home versus
foreign deposits? Explain briefly.
f. Repeat (e), assuming a floating exchange rate regime and that investors expect a
fiscal policy response.
Answer: The fiscal policy response stabilizes exchange rates, so the investors will
10. In the years leading up to the Great Depression, a key objective, or rule, of the federal
government was to balance the government budget.
a. Suppose that tax revenue collected by the government depends on income. During
a recession, what happens to government’s tax revenue? What does this imply
about the government budget?
Answer: Government tax revenue declines during a recession because households
b. If the government wants to keep the budget balanced, what type of fiscal policy
must the government implement? Illustrate the effects of this policy using the IS‒
LM–FX model and assuming a floating exchange rate regime.
Answer: To balance the budget, the government would need to implement a
c. State how the fiscal policy affects Y, i, E, C, I, and TB. Is this fiscal policy a
stabilization policy? Explain.
d. In reality, the United States was part of the gold standard, fixing its exchange rate
to the value of gold. Illustrate how the fiscal policy you described in (b) affects
the economy differently under a fixed exchange rate regime. State how the fiscal
policy affects Y, i, E, C, I, and TB in this case.
Answer: To prevent the depreciation in the dollar, the Federal Reserve would
e. Consider the limitations on stabilization policy in practice. Which limitation does
this scenario highlight? Explain.
Answer: This scenario illustrates the problem of policy constraints. When policy
11. Determine whether each of the following statements regarding the limitations of
stabilization policy for the United States is true or false. Include a diagram or
explanation to support your answer.
a. Inside lags are a bigger problem for monetary policy compared with fiscal policy.
Answer: False. Fiscal policy faces severe institutional barriers because of the way
b. If households engage in consumption smoothing, then tax cuts have a smaller
effect on output.
Answer: True. If households smooth consumption, they will not respond much to
c. If there is relatively weak pass-through from nominal to real exchange rates, then
a fiscal expansion will have a larger effect on output.
Answer: True. A fiscal expansion leads to an appreciation that reduces the trade
d. The existence of pegged currency blocs limits the ability of both monetary and
fiscal policy to affect output.
Answer: False. The existence of pegged currency blocs limits the ability of
e. If there are smaller transaction costs associated with trade, then a fiscal
contraction will lead to a larger reduction in output.
Answer: False. When transaction costs are smaller, the effects of fiscal