 # Consider an hypothetical economy in the short-run with fixed prices...

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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 + 0.85(Y − T) I = 760 − 50i G = T = 0 X = 50 + 3E Q = 0.05Y + 4E Ms/P = 100 L(i, Y ) = 0.1Y − 20i i = i ∗ + E e−E E Answer the questions below using the following (simplified) definition for Aggregate Expenditure (i.e. NOT multplying import quantities by the real exchange rate – to simplify the mathematics). AE = C + I + G + X − Q 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 ∗ = 0.05 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 the solution with the lowest non-negative interest rate.) iv) Is the domestic economy in part iii) above running a trade surplus or trade deficit? (2 marks) v) Assume that the government engages in a balanced-budget expenditure program whereby now G = T = 100. Solve for the new equilibrium values of income (Y), interest rates (i), and exchange rate (E) under this new fiscal policy. Illustrate your answer in a graph. (4 marks) 1vi) How does this new fiscal policy impact the domestic economy’s trade balance? (2 marks) vii) Starting from the situation as in part v) above, assume now that the foreign interest rate rises to i ∗ = 0.10. What would the effects be on Y, i, and E?. (4 marks) viii) How would the higher foreign interest rate affect the domestic economy’s trade balance compared to your answer in part vi)? (2 marks) ix) Starting again from the siutation as in part v) above, but assuming that there is a “fixed exchange rate regime” with E = E¯ = 1.0 what action, if any, would the monetary authority have to take in response to the new balanced-budget expenditure program? (4 marks).

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(i) The equation for the IS curve is given as
Y= AE = C+I + G+X-Q
Y= 700+0.85Y +760-50i +50+ 3E-0.05Y – 4E
Y-0.85Y+0.05Y = 700 + 760 + 50 -50i -1E
0.2Y = 1510-50i-1E
Y= 7550-250i –5E...

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