Chap 15 solution - CH 15 SOLUTIONS TO TEXTBOOK PROBLEMS...

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CH 15 SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1. In a closed economy, a decrease in the money supply increases the equilibrium interest rate. The decrease in the money supply reduces aggregate demand because the higher interest rate causes households to buy fewer houses, reducing the demand for residential investment, and causes firms to spend less on new factories and new equipment, reducing business investment. In a small open economy, a decrease in the money supply causes the exchange rate to rise, which causes exports to fall and the aggregate demand curve to shift further to the left than it would in a closed economy. 2. A decrease in the money supply shifts the money-supply curve to the left causing interest rates to rise, thereby shifting the aggregate-demand curve to the left. 3. The effect of a reduction in government spending is different in a closed vs. an open economy, as follows: a. In a closed economy, a reduction in government spending causes the aggregate demand for goods and services to fall, causing the aggregate demand curve to shift leftward because government purchases are lower. The shift to the left of the aggregate-demand curve could be more than the initial reduction in spending because of the multiplier effect or it could be less because of the crowding-out effect.
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b. In an open economy under a flexible exchange rate, the contractionary fiscal policy causes Canada’s interest rate to fall below the world interest rate and the exchange rate to depreciate causing net exports to rise, thereby increasing aggregate demand. c. In an open economy under fixed exchange rates, the Bank of Canada fixes the value of the exchange rate so a reduction in government spending causes the money supply to fall which adjusts the Canadian interest rate to equal the world interest rate. 4. A reduction in government spending reduces the demand for money and the interest rate, shifting the AD curve to the left. If the economy is open and the exchange rate is flexible, these effects are offset by the depreciation of the currency and an increase in net exports. If the exchange rate is fixed, the effect of a reduction in government spending on aggregate demand is enhanced by a reduction in money supply whose purpose is to prevent the depreciation of the currency. Questions for Review 1. The theory of liquidity preference is Keynes's theory of how the interest rate is determined. According to the theory, the aggregate-demand curve slopes downward because: (1) a higher price level raises money demand; (2) higher money demand leads to a higher interest rate; and (3) a higher interest rate reduces the quantity of goods and services demanded. Thus the price level has a negative relationship with the quantity of goods and services demanded.
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