# PROBLEM SET 6 -- Principles of Macroeconomics

Posted Wednesday, October 25, 2000

Due Wednesday, November 1, 2000

1. Fiscal policy is more efficient under a regime of flexible exchange rates than fixed exchange rates.

1. Monetary policy is more efficient under a regime of flexible exchange rates than fixed exchange rates.

1. Under a flexible regime, if sudden news makes people expect a large depreciation (large expected E) in the future, then output will go up.

1. Under a fixed regime, if sudden news makes people expect a large devaluation (large expected E) in the future, then output will go up.

1. If money supply increases, interest rates will go down.  Therefore – by the interest rate parity condition – domestic currency will appreciate relative to the currencies in other countries with higher interest rate levels.

1. The twin deficits refer to the government's budget deficit and private deficit.

2. OPEN ECONOMY IS-LM   (40  points)

Consider the following open economy where foreign variables are marked with a star (*).  (You might want to use some mathematical software to solve the different systems of equations, e.g. MAPLE or Matlab.  Alternatively, since there is a quadratic expression, you can factor/ use the quadratic formula and choose the logical root.)

C  = 24 + 0.4(Y - T)

I =  80 - 50i

X = (30 + 0.2Y*)E

Q = (10 + 0.4Y)/E

Md = Y - 20i

M/P = 80

P = 1

P* = 1

Y* = 100

Ee  = 1.95

G = 10

T = 10

i* = 0.05

1. Does the Marshall-Lerner condition hold?
2. Write the expression for the goods market equilibrium with i and E fixed.
3. What is the multiplier (with i and E fixed)?
4. Write the LM equation.
5. Write the interest rate parity equation.
6. What's the equilibrium value of output, interest rates, and net exports in this economy?
7. Graph i as a function of E.
8. Graph the LM curve.
9. In the above graph, draw the IS curve for different exchange rate levels.
10. If G goes up to 20, what happens to output and net exports in equilibrium?  What are the new equilibrium values of E and i? Explain.
11. Answer the previous question (j) if, instead of an increase in G, M increases to 200.
12. Answer the same question (j), but now the only change is in the perception of future exchange rates (G and M are back to the original assumptions.)  Assume that expected E (Ee ) is now equal to 2.5.
13. Go back to the original model but assume that exchange rates are fixed and equal to 1.  Now answer question (i) and (j).  Explain the difference with respect to the flexible exchange rate regime.

3.  EXCHANGE RATES AND EXPECTATIONS  (12 points, 4 per question)

Consider an open IS-LM economy with fixed exchange rates E = 1, and with

i=0.15, i*=0.6.

1. What's the exchange rate people expect (Ee) in this market?
2. What will happen if people are right and the Central Bank devalues the currency to the level people think is correct?  In particular, what happens to interest rates and output?
3. How does your answer change if,  after the devaluation,  people start thinking that the Central Bank is 'weak' and believe that it will start printing lots of money?