Answer: The increase in government spending leads to a rightward shift in the IS
curve. This leads to an increase in home country’s interest rate and an implied
b. The Eurozone countries decrease the money supply.
Answer: The decrease in foreign money supply leads to a leftward shift in the
LM* curve. This leads to an increase in foreign country’s interest rate, i*, and an
c. Investors expect a depreciation in the Bulgarian lev relative to the euro.
Answer: This increases the return on foreign deposits, leading to a depreciation in
the home currency, shifting IS to the right. The result is an increase in home
3. The Chinese government manages the value of the Chinese yuan relative to the U.S.
dollar. Between 1995 and 2005, the yuan was strictly pegged to the dollar at a rate of
roughly 8.28 yuan per dollar with a slightly looser peg adopted in 2006. By early
2017, the yuan was trading at 6.90 per dollar. China’s central bank, the People’s Bank
of China (PBC), is responsible for using monetary policy to defend the fixed
exchange rate. As a result of government policy geared toward spurring capital
investment, China experienced a significant increase in investment demand.
a. Using the IS‒LM diagram for Home (China) and Foreign (the United States)
illustrates the impact of this policy, assuming that the PBC responds to maintain a
fixed exchange rate.
Answer: See the following diagram.
b. How would this policy and central bank response affect the government budget,
current account, domestic interest rates, and output?
c. How would China’s experience be different if the PBC allowed the yuan to float
against the U.S. dollar? What would be the implications for China’s exports to the
United States? For China’s imports from the United States?
Answer: If the yuan floats against the dollar, the increase in investment demand
d. In practice, China uses capital controls to fix its exchange rate. How does this
affect the previous answers? In the case of capital controls, is the outcome more
similar to the fixed case in (a) or the floating case in (c)?
Answer: In the case of capital controls, China can allow the interest rate in China
4. During the mid-1990s, Mexico maintained an exchange rate peg against the U.S.
dollar. When President Zedillo took office in December 1994, he faced several
challenges. A combination of the assassination of a presidential candidate (Luis
Donald Colosio) and the rebellion in Chiapas had led to an increase in the expected
future exchange rate, Eepeso/$.
a. Using the IS‒LM diagram for Home (Mexico) and Foreign (the United States)
illustrates the impact of this change in investor expectations, assuming the Banco
de Mexico responds to maintain a fixed exchange rate.
Answer: See the following diagram. Point B shows the floating exchange rate
b. How would the change in exchange rate expectations and the subsequent central
bank response affect the government budget, trade balance, domestic interest
rates, and output?
Answer: Mexico’s central bank is forced to cut the money supply to prevent an
c. When president-elect Ernesto Zedillo took office, he was forced to make a
decision between either establishing an exchange rate band (effectively floating
the peso against the dollar) or continuing the monetary policy mentioned
previously. President Zedillo decided to establish an exchange rate band. The
former President Salinas referred to Zedillo’s policies as “el error de diciembre,”
or “the December mistake.” Do you believe this decision was a mistake? Explain,
considering the trade-offs between output stabilization and exchange rate stability.
Answer: Based on the previous diagram, we can see why President Zedillo may
d. Suppose that a large share of Mexico’s external debt is denominated in U.S.
dollars. How does this affect your answer to (c)?
Answer: If a large share of Mexico’s external debt is denominated in U.S. dollars,
then a depreciation in the peso could have added costs in terms of valuation
5. Consider a noncenter home country that is part of a fixed exchange rate regime. The
home country currently has output higher than its desired level. Concerned about
inflationary pressures, central bankers want to contract the money supply. Using the
IS‒LM diagrams for a home and a foreign country, show how each of the following
would affect home and foreign output. In which cases are the monetary policy
objectives inconsistent with the home country remaining in the fixed exchange rate
regime?
a. The foreign country is a center country. Compare a cooperative versus a
noncooperative adjustment in interest rates.
Answer: See the following diagram. In the noncooperative case, there is little the
home country can do. It remains at point A, unable to use monetary policy to
achieve output stability. In the case of a cooperative agreement, the foreign
b. The foreign country is a noncenter country. Compare a cooperative versus a
noncooperative adjustment in exchange rates.
6. During the 1980s, several Latin American countries had currencies pegged to the U.S.
dollar. Consider three such countries: Belize, Bolivia, and Mexico. A larger share of
Mexico’s exports was/is sold in the United States relative to Belizean and Bolivian
exports to the United States. In addition, Mexico shares a large geographic border
with the United States, whereas Belize is located further south in Central America,
with coastal access to the United States through the Caribbean Sea. Bolivia is located
in South America and is landlocked. Compare and contrast these three countries in
terms of their likely degree of integration symmetry with the United States. Plot
Belize, Bolivia, and Mexico on the symmetry–integration diagram relative to the
United States.
Answer: See the following diagram. Although it is not possible to determine the
position of the FIX line without more information, we know that Mexico is in the
7. Several countries that have experienced political and economic stability adopt a fixed
exchange rate regime to draw on the potential benefits, such as fiscal discipline,
seigniorage, and expected future inflation. To what extent do you believe these
potential benefits differ in cooperative versus noncooperative fixed exchange rate
systems?
Answer: Cooperative exchange rate systems are generally more successful than
noncooperative regimes. Countries can compromise on adjusting interest rates or
8. In the context of the trilemma, compare and contrast the dissolution of the gold
standard during the 1920s and 1930s to the collapse of the Bretton Woods system
during the 1960s and early 1970s. In what sense did the Bretton Woods system
attempt to address the problems associated with the gold standard? To what extent did
the Bretton Woods system strengthen or weaken a country’s ability to maintain a
fixed exchange rate?
Answer: The gold standard collapsed for a combination of reasons:
9. The International Monetary Fund (IMF) is often viewed as an international lender of
last resort. When countries seek out loans from the IMF to alleviate banking and
economic crises, the IMF often requires countries to maintain a fixed exchange rate.
Why do you suspect the IMF pressures countries with large levels of foreign-
denominated debt to maintain fixed exchange rates? Do you believe this is a good
policy? Discuss possible alternatives.
Answer: The IMF might require a fixed exchange rate regime as a condition of
lending to dissuade countries from defaulting on their external debt denominated in a