Government Expenditure and Fixed Exchange Rate.

The Chinese Renminbi was pegged to the USD before July 2005. Using the IS-LM-FX model for Home (China) and Foreign (US), illustrate how a decrease in G in China before July 2005 affected the following Chinese variables (increase, decrease, no change, or ambiguous): Y , i, E, C, I, TB. Do not forget to use a diagram to support your answer. For the purposes of this problem assume international capital mobility.

Answer True or False. Briefly explain your answer. No credit without explanation.

1) A country fixing its exchange rate to the US dollar cannot hold its US dollar exchange rate constant if it sets its domestic interest rate equal to the dollar interest rate. Do not forget to use equations to support your answer. Assume free capital mobility and a credible fixed exchange rate. Explain carefully.

2) At high levels of symmetry and/or integration, above the fix line, it makes sense to fix. Atlow levels of symmetry and/or integration, below the fix line, it makes sense to float.

3) When real income temporarily decreases, the central bank can maintain the exchange ratefixed at E0 by selling foreign assets.

4) Relative to a country with a fixed exchange rate, an economy with a floating exchange rate isless vulnerable (i.e., its level of output is less sensitive) to shocks coming from the domestic money market (e.g. money demand shocks).

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, TB. Assume a flexible exchange rate.

a All else equal, there is an increase in the foreign interest rate.

b All else equal, the real demand of money falls.

IS-LM Schedules.

Suppose you are the TA of Econ 3602 and one student does not know how to derive theIS schedule. Show this student how to derive the IS schedule. Support your answer with equations and figures.

One week later the same student comes to your office hours and now asks you to derive theLM schedule. Show this student how to derive the LM schedule. Support your answer with equations and figures.

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, TB. Assume a fixed exchange rate.

a All else equal, the real demand of money falls.

b All else equal, there is a decrease in taxes.