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
Answer the questions below using the following (simplified) definition for Aggregate 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 program 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. Illustrate your answer in a graph. (4 marks)
1vi) How does this new fiscal policy impact the domestic economy’s trade balance? (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
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...