Flexible Exchange Rates and Economic Policies

In the IS-LM-BP model suppose the consumption function and the investment function are, respectively:

C = 10 + 0:9Y
I = 10 100r

Where C is consumption, I is private investment, Y is GDP, and r is the interest rate. The current account and the nancial account functions are:

CA = 2E 0:15Y
FA = 1356r

Where E is the exchange rate (units of the domestic currency per units of the foreign currency), CA is the current account, and FA is the nancial account. For simplicity, assume that the current account is equal to net exports. The money demand function is:

M^D = 2Y 200r

Government expenditures are equal to 100, and money supply is M = 934.

a) Interpret equations (1), (2), (3), (4) and (5). Is this a small country?
b) Derive the IS, LM and BP curves.
c) Compute the equilibrium levels of E, r and Y .
d) Suppose that the exchange rate is exible and that money supply increases to M₀ = 940. Compute the new equilibrium and represent the shift graphically. What happens to income, the interest rate and the exchange rate?

What about the current account? Give the intuition behind your results.

e) Suppose that you start at the equilibrium that you found in c), and then government expenditures go up to 110. Without doing the algebra, can you say something about the changes in Y , r, and E? Justify your answer.