ss09 - University of Toronto Economics Department...

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University of Toronto Macroeconomics, Theory and policy Masoud Anjomshoa Economics Department Solution set #9 Disclaimer: These solutions are just guidelines for you, and may NOT include a complete solution for the questions and problems in your homework, as you must present in your assignments and/or exams. In your solutions you must show your work, and demonstrate your line of thinking clearly. Please, always check my calculations for unintentional typos or miscalculations. --------------------------------------------------------------------------------------------------------------------------------- 1- a)- After devaluation of exchange rate from Ē to Ē’, interest parity curve shifts to the right, therefore NX curve shifts up, and trade balance improves. The trade balance improvement leads to increase in demand for domestic goods, and shifting IS curve to the right. Output tends to go up, and there would be upward pressure on interest rate to go above foreign interest rate, which would initiate a capital inflow and exchange rate appreciation. Therefore, the Central Bank must impose monetary expansionary policy to support fixed exchange rate, and keep the exchange rate constant, leading to a downward shift in LM curve up to the point where the interest rate remains the same at the foreign interest rate level. (see the graph below). Notice that I started from a balanced trade situation i i UIP’ E IS’ E e IS i=i* Y LM i=i* NX Y Y + 0 _ Y Y’ LM’ E e ’=Ē’ NX’ Y’ NX UIP
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b)- In this case, the fixed exchange policy will not be credible, therefore while the Central Bank sets the rate at Ē’, the expected exchange rate goes further up, above the fixed exchange rate level to E e ’. Changing the expected exchange rate would cause a right shift in the interest parity curve. This leads to a capital outflow, and the Central Bank needs to sell foreign exchange to defend its rate, Ē’. This would be contractionary monetary policy, shifting LM up. Also devaluation cause NX improvement, shifting NX and IS curves. Finally this in turn leads to increase in output and interest rate.
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ss09 - University of Toronto Economics Department...

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