f01_ps5ans1 - Problem Set 5 Answers 14.02 Fall 2001 1 True...

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Problem Set 5 Answers 14.02 Fall 2001 1 True or false, explain 1. False. It is true for gross exports, since a real devaluation makes domestic goods cheaper and hence increases the demand for them. For net exports it is only true if the Marshall-Lerner conditions are met. 2. False, expansive fi scal policies increase the interest rate making domestic bond prices fall and hence making them more atractive for investors. A revaluation of the currency follows. 3. False. Under fi xed exchange rates, the increase in demand caused by the government is magni fi ed due to the increase in money supply that is required to keep interest rates at international levels. 4. False With fi xed exchange rates, money supply must be contracted to maintain the interest rate at the international level importing the whole of the international recession into the country. However, government spending can compensate any fall in exports without any change in money supply. 5. False, the di ff erence between the two must also be larger than the percentage change in the real exchange rate. 6. True. This is what is stated by the Marshall-Lerner Condition. 2 Policy Abroad Questions 1. Abroad, the money market will have very di ff erent equilibrium interest rates for levels of income that will be only slightly di ff erent. The LM will be very steep. 1
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2. Since the LM is steep an expansionary fi scal policy abroad will in- crease the international interest rate with no impact on foreign out- put. In the foreign money market, money demand has expanded swiftly driving interest rates up. In the foreign goods market, the excess demand created by the government abroad is compensated by a fall in investment. There is no e ff ect on the demand for do- mestic exports. However, since the exchange rate is fi xed, domestic interest rates must go up and domestic demand for investment will fall. 3. Abroad the LM will be very fl at. Any money that the foreign central bank issues does not expand saving but, rather, is stored by the agents.
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