Question

3. Now, Assume that Peruvian government responds by using monetary policy to stabilize output after a shock. For each of the following situations, use the IS-LM-FX model to illustrate the effects of the shock and the policy response. For each case, state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, TB. a. Peru's main trading partner, China, enters into a recession. China's output decreases. b. Investors expect a depreciation of the Sol, the Peruvian currency. c. The money supply in Peru increases. d. Peruvian government increases government spending.

Answer 1

Y= Output

i= nominal interest rate

E= Nominal Exchange rate

C=Consumption

I= Investment, Negatively related to real interest rate

TB= Trade Balance or net export; positively related to real exchange rate, q=EP*/P

a. Peru's main trading partner, China enters into a recession. China's output decreases.

-> Given, Y for china decreases, nominal interest rate,i is ambiguous as by definition, it also depends on inflation rate that will go down during a recession

-> Nominal exchange rate, E= P*/P, for China will increase, while, for Peru will decrease

-> TB will decrease due to lower demand from China for Peruvian goods

-> Consumption is ambiguous

b. Investors expect a depreciation of the SoI, the Peruvian Currency

Y will go up as demand for Peruvian Goods increases

i will go down as per IS curve

E goes up as Peruvian currency is expected to decrease

Consumption will increase, as it is a positive function of Y

Investment will increase as it is negatively related to i (lowered borrowing cost), and as per expectations of currency depreciation, investors will invest more money

TB will increase as it is positively related to E

c. The money supply in Peru increases

increased money supply in Peru will lead to currency depreciation and same effects as (b)

d. Peruvian Government increases Government Spending

Increased Government spending will lead to increase in Output and employment

i is ambiguous as Output increases, but crowding out may also occur

Lower consumption as there is a negative wealth effect

Domestic currency appreciates due to which E will decline; similarly TB will also decline as exports from Peru become less competitive