Question

P al ance in the short run? Use graphics 4. (3 pts) Suppose a small open economy characterized by the following equations: Consumption: C-20+0.8(Y-T), where Y is national income and T are taxes. Investment:I-40-2.15r, where r is the domestic interest rate Government expenditures: G-50 T=50 Money supply: M-590 Demand for money: L-Y-7r Net exports: XN-114-50e oreign interest rate: r-8 Domestic price level constant: P- a) Solve for the equilibrium of income, the exchange rate and the trade balance. b) Suppose that there is an increase of the money supply of 50 units. Solve for the new values of income, trade balance and the exchange rate if this is fully flexible c) What should the Central Bank do to keep the exchange rate constant and equal to the level obtained in part a? What is the new level of income and net exports in this case? d) Draw graphics and diagrams

Answer 1

Assuming perfect capital mobility, r = r = 8, so at Eq mM^s = M^d = 590 = y minus 7 times 8 = 590 + 56 = y* Money M k t eq^m: y^alpha = 646 open Economy IS: y = C + G + I + NX y = 20 + 0.8 (y minus 50) + 50 + 40 minus (2.15 times 8) + 114 minus 50 e. = .2 y = 166.8 minus 50 e = 50 e = 166.8 minus 129.2 = 37.6 e^alpha = .752 Trade Balance NX = 114 minus 50 e^alpha NX^alpha = 76.4 b) Now M s' = 50 + 590 = 640. So new y* = 640 = y minus 56 y' = 696. So 50 e = 166.8 minus .2 times 696 = 166.8 minus 139.2 = 27.6 e^alpha = .552 NX' = 114 minus 276 = NX' = 86.4