Question

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 (increase, decrease, no change, or ambiguous) on the following variables: Y, i, E, C, I, TB. Assume the government allows the exchange rate to float. a. Lump-sum taxes increase. b. Foreign income increases. c. Investors expect an appreciation of the home currency d. The money supply decreases.

Answer 1

Answer: 1) Lump-sum taxes increase: Floating (B): YT, it, Et Fixed (C): Y , i and E unchanged ERA 14 - - DR1 A=C 12 - --- DR2 III - - - FR1 - - EH/F Y Y2 73 E E2 4) The money supply decreases: LM shifts left Ytit,E 1, ct, IV, TBV LM ER, - - IL.. . ...i i i FR Y 2 Yi v Ez E

2) Foreign income increases: In the enclosed diagram the Point B displays the outcome with floating exchange rates while the Point C displays the outcome with fixed exchange rates Floating (B): Yt, it, E. Fixed (C): Y , i , E unchanged LM LM3 11 E -- -- - - - - - - DR -- DR2 DR3 - INC -- IS, FR FR Y2 Yz Y, EZE EHF 3) Investors expect an appreciation of the home currency: An expected appreciation of Home currency indicates that investors expect a lower return on Foreign deposits, thus in enclsoed graph FR shifts down and the IS curve would shifts to the left (B). ------ DR - - DR2 + -- 7XL--- ----- LC DR3 Zi1S2 TIS, FR Y2 Y₃ Y, E, E EH/F