1. IS-LM-FX Model with Floating Exchange Rate
For each of the following situations use the IS-LM-FX model to illustrate, first, the effects of the temporary shock, and then the policy response. (Note: Assume the central bank responds by using monetary policy to stabilize output (i.e. to keep it at the initial equilibrium).) Label A the initial equilibrium, B the short-run equilibrium without policy response, and C the equilibrium after the response of the central bank. For each case, state the effect of the shock on the following domestic variables (increase, decrease, no change, or ambiguous): Y , i, E, C, I, T B. Assume a flexible exchange rate.
a All else equal, the real demand of money falls.
b All else equal, there is an increase in the expected nominal exchange rate.
2 IS-LM Schedules.
a Suppose you are the TA of Econ 3602 and one student does not know how to derive the IS schedule. Show this student how to derive the IS schedule. Support your answer with equations and figures.
b One week later the same student comes to your office hours and now asks you to derive the LM schedule. Show this student how to derive the LM schedule. Support your answer with equations and figures.
c Suppose the economy is in full employment and suddenly there is a fall in the domestic price level (P ). What would happen to output and the current account (net exports) in this economy?
3 Answer True or False. Briefly explain your answer. No credit without explanation.
a If Mexico is fixing the Mexican peso to the US dollar and the FED (the central bank of the USA) raises interests rates, then the Mexican central bank will have to increase its Money supply to keep its Mexican Peso/US dollar exchange rate fixed. Assume that Mexican and American assets are equally risky and liquid. Use a graph of the IS-LM-FX model to support your answer. Explain carefully.
b Consider a country Z thinking of pegging its currency to the euro as a base currency. If this country has a FEAR OF FLOATING, then it would be willing to peg its exchange rate at higher levels of integration and similarity. Use a diagram to support your answer. Explain carefully.
c At very low levels of market integration and very high levels of symmetry it makes sense to choose a floating exchange rate regime. Do not forget to use a graph to support your answer. Explain carefully.
4 IS-LM-FX Model with Fixed Exchange Rate
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 on the following domestic variables (increase, decrease, no change, or ambiguous): Y , i, E, C, I, T B. Assume a fixed exchange rate .
a All else equal, there is an exogenous increase in investment.
b All else equal, the real demand of money falls.
5 Taxes.
The Estonian kroon is currently (in 2007) pegged to the euro. Using the IS-LM-FX model for Home (Estonia) and Foreign (Eurozone), illustrate how an increase in taxes in Estonia affect the following variables (increase, decrease, no change, or ambiguous): Y , i, E, C, I, T
B. Do not forget to use a diagram to support your answer.