>	Econ 100b Created 4/30/1996 Go to Brad De Long's Home Page

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P-Set Six Answers

International Economics

Economics 100b; Spring 1996; Brad DeLong

Because the (Y, e) graph is drawn with the exchange rate, not the interest rate on the vertical axis: the interest rate is a constant r*, fixed by international capital maket.

2. Suppose that, in the Mundell-Fleming model, the equilibrium exchange rate is above the level e' at which the central bank wishes to keep the currency. Suppose that the central bank takes steps to peg the exchange rate to e'. Which curves shift--the IS*, the LM*, or both--and why?

The LM* curve shifts outward; the central bank must keep buying and buying foreign currency assets--and printing and printing domestic money to do so. The domestic money supply expands, and the exchange rate falls.

3. What must be true about elasticity of demand for imports and exports, if net exports are to be a decreasing function of the real exchange rate?

At least one of the two elasticities must be greater than one--so that expenditure on imports (and not just quantity) actually falls when the exchange rate appreciates; or so that expenditure on exports (and not just quantity) actually rises when the exchange rate depreciates. But the full set of conditions belongs in a 18x course

4. Suppose exchange rates are fixed: is the imposition of a tariff expansionary or contractionary? Suppose exchange rates are flexible. Is the answer the same? Why or why not?

Imposition of a tariff shifts the IS* curve and is expansionary under fixed exchange rates. Under flexible exchange rates the exchange rate appreciates, but the tariff is neither expansionary nor contractionary (unless it affects the deficit).

5. In the Mundell-Fleming model under flexible exchange rates, what happens to production, the exchange rate, and the trade balance if the world interest rate r* suddenly rises?

The IS* curve shifts back (because the domestic interest rate rises, and so investment falls). The LM* curve shifts out (because the higher domestic interest rate increases the velocity of money. The exchange rate falls a lot; output rises a little; the trade balance improves a little.

6. In the Mundell-Fleming model under fixed exchange rates, what happens to production, the exchange rate, and the trade balance if the world interest rate r* suddenly falls?

The IS* curve shifts back (because the domestic interest rate rises, and so investment falls). The LM* curve shifts back as well as the central bank cuts the money supply in order to keep output from falling. The exchange rate stays constant (and the trade balance stays constant). Output falls a lot.

The Mundell-Fleming model can be used to analyze California's relationship with the rest of the country--if we consider California to be a "small open economy" with a fixed exchange rate to the rest of the U.S.:

7. Suppose that the state government had used "fiscal policy" to try to alleviate the depression of 1991-1993 in California by cutting state taxes and expanding spending. Does the Mundell-Fleming model predict that such a policy would have been a successful anti-California depression policy? Why or why not?

It would be very effective. Expansionary fiscal policy is very effective at boosting output in a small open economy with fixed exchange rates.

8. Suppose that the state government has used "monetary policy" to try to alleviate the depression of 1991-1993 in California by reducing reserve requirements of state-chartered banks--so that such banks would be able to support a larger supply of deposits and loans. Does the Mundell-Fleming model predict that such a policy would have been a successful anti-California depression policy? Why or why not?

It would be ineffective. Attempts to expand the money supply in a small open economy immediately leak out into the wider world under fixed exchange rates.