Question

B3. Open Economy IS-LM-FE model: The behaviour of households and firms in an open economy is represented by the following equations: Full-employment outputY-1200 red consumption Cd = 350 + 0.5Y-200r : Desired investmentd 250-300r Government purchasesG 95 Net exports : NX = 100-01-05e Real exchange rate : 90. Assume that the real interest rate, r, does not deviate from the foreign interest rate and that the economy is initially in general equilibrium. ve the open-economy IS curve writing the real interest rate on the left side of the equation (b) The LM curve for this economy is described by 4000 where P denotes the price level and M denotes the nominal money supply. Assume M 480. What are the general equilibrium values of r and P? Ilustrate this general equilibrium using the IS-LM-FE diagram. (c) Suppose that this economy has a flezible nominal exchange rate and that the government decides to impose an import quota in order to restrict imports. What would be the short-run effect of this policy on Y, NX, and e holding the price level P constant (no calculations necessary)? Illustrate the effects using the IS-LM-FE diagram. (d) Suppose instead that this economy has a fixed exchange rate. What would be the short- run effect of this policy on Y, NX, and e holding the price level P constant (no calculations necessary)? Illustrate the effects using the IS-LM-FE diagram. (e) Explain the process that restores the economy to general equilibrium under fixed ex- change rates. How do the Keynesian and classical views differ on this process? 10

Answer 1

Given: Y^cap = 1200 C^d = 350 + 0.5y - 20r I^d = 250 - 300r G = 95 NX = 100 - 0.1Y - 0.5e e = 90 Is curve derivation (let Y = Y^cap) Y = C + I + G + NX Y^cap = 350 + 0.5Y^cap + 250 - 20r - 300r + 95 + 100 - 0.1Y^cap - 90(0.5) 1200 = 795 + 0.5(1200) -.1(1200) - 320r - 90(0.5) 1200 = 795 + 480 - 45 - 320r 320r = 1230 - 1200 r = 30/320 = 0.09375-(1) r = Y - M/P/4000 (M = 480) Al equation Is and LM interest with other so, putting r value from equation (1) we can get price 0.09375 = 1200 - 480/9/4000 375 = 1200 - 480/p doublerightarrow 480/p = 1200 - 375 = 825 p = 480/825 = 0.5818 C) when import quota is imposed than the term of trade of domestic country will improve. As a result the IS curve will shift to the right due to which the interest rate and output will improve.

C) when import quota is imposed than the term of trade of domestic country will improve. As a result the IS curve will shift to the right due to which the interest rate and output wil improve. When the domestic interest rate increases this will result in capita inflow because investor will speculate to enhance their return. Due to the capital inflow the domestic currency demand will increase which will appreciate the currency. The appreciation of country will make the import cheaper because now domestic consumer will be able to buy larger quantity of good by spending same money. The increasing import will deteriorate the terms of trade and IS curve will shift leftward until the point of world ineterest and domestic interest rate. Therefore equilibrium will be attain at the equalization of goods, money and exchange rate.