Consider an hypothetical economy in the short-run with fixed prices (including foreign prices) and
characterized by the following equations (all variables as defined in class).
C = 700 + 0.8Y
I = 500 − 40i
G = T = 0
X = 5 + 2E
Q = 0.1Y − 4E
/P = 200
L(i, Y ) = 0.6Y − 90i
i = i
Ee − E
i) What is the equation for the IS curve? (4 marks)
ii) What is the equation for the LM curve? (4 marks)
iii) Given i
∗ = 0.03 and Ee = 1.0, solve for the equilibrium values of income
(Y), interest rates (i) and the exchange rate (E). (4 marks) (HINT: Using the
quadratic formula will give you two possible solutions. Pick either the positive
or lowest positive value.)
iv) Is the domestic economy’s exchange rate expected to appreciate or to depreciate? (2 marks)
v) Is the domestic economy running a trade surplus or trade deficit? (4 marks)
vi) Assume that the government engages in expansionary fiscal policy by increasing expenditure to G = 50. Solve for the new equilibrium values of income
(Y), interest rates (i), and exchange rate (E). Illustrate your answer in a graph.
vii) How does this expansionary fiscal policy impact the domestic economy’s
trade balance? (4 marks)
viii) Now, assume that for the economy as in part iii) the foreign interest rate
rises to i
∗ = 0.04. Solve for the new equilibrium (Y,i,E) combination. How does
the higher foreign interest rate affect the domestic economy’s trade balance
compared to the situation in parts iii)? (4 marks)
ix) Now, assume that a trade agreement between this economy with G = 0 and
the “foreign” economy with i
∗ = 0.03 establishes a fixed exchange-rate regime
with E = ¯ = 1.5. What would the equilibrium values of (Y,i,E) be in this
example? (4 marks).
x) Is the domestic economy’s exchange rte expected to appreciate or to depreciate? (2 marks)
x) What would the effects of the expansionary fiscal policy of part v) be under
the fixed exchange-rate regime? (4 marks).
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