Question

Economics 303(02) Assignment 2 continued Page 2 of 2 Question 3 (10 Marks): Assume that Canada is a small open economy which uses a system of fixed exchange rates. The economy is in equilibrium when there is a sudden decrease in real money demand. Explain what will happen to the exchange rate, output, and the real interest rate in the short-run and in the long-run.

Answer 1

3. The IS bend catches the market for products and ventures. The bend portrays the harmony condition where the stockpile of merchandise and ventures is equivalent to the interest. The Mundell-Fleming model is a very useful tool when dealing with the analysis of open economies.

The equilibrium of the currency market infers that, given the measure of cash, the interest rate is an expanding capacity of the output level. At the point when output builds, the interest for cash raises, yet, as we have stated, the cash supply is given. Along these lines, the interest rate should ascend until the contrary impacts following up on the interest for cash are dropped, individuals will request more cash as a result of higher pay and less because of rising interest rates.

The primary forecast from the Mundell-Fleming model is that the conduct of an economy depends significantly on the exchange rate framework it embraces, i.e., regardless of whether it operates a gliding exchange rate framework or a fixed exchange rate framework. We start with change under a drifting exchange rate framework, in which case there is no national bank intercession in the remote exchange market.

In the long run, money prices of factors of production and of goods and services are allowed to adjust to demand and supply in their respective markets. Increasing the level of output the short run when the price level is inflexible.