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ps10ans - Economics 202 Principles of Macroeconomics Name...

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Economics 202 Name: _______________ Principles of Macroeconomics Professor Melick Problem Set #10 Due Friday May 2, 2008 1. Using the attached Figure 1 and the assumption of a classical model with misperceptions for an open economy illustrate and explain the short-run and long-run effect on only the domestic economy of a sharp drop in GDP in the rest of the world ( ) For Y . In each of the six graphs show only three points, an initial general equilibrium before the change in For Y (labeled point A), the short-run equilibrium after the change in For Y (labeled point B), and the new long-run general equilibrium (labeled point C). Discuss what happens to the current account, real exchange rate and nominal exchange rate for the domestic economy. For consistency, start the domestic economy off with a current account deficit. Please refer to the 3 figures labeled 1. The drop in For Y will lead to a fall in net exports as X falls. This will shift the IS curve to the left, leading in the short-run to a drop in income, a fall in the real interest rate and a drop in the price level. Long-run equilibrium is restored by a further drop in the price level that shifts LM’ to LM’’ and shifts SRAS to SRAS’. In the foreign exchange market initially we have the demand for dollars falling as a result of the drop in For Y . In the short run we have: a decrease in Y that will shift the supply of dollars back as fewer imports are purchased, a decrease in the real interest rate that will make foreign assets look more attractive thereby pushing the supply of dollars out and the demand for dollars back, a drop in the price level that will push the supply of dollars back and the demand for dollars out as U.S. goods look cheaper. On balance, we assume that the supply of dollars shifts back as does the demand for dollars (relative to the already depressed demand given the drop in For Y ). We move to point B. In the long-run, Y returns to its original value (pushing supply out), real interest rates continue to drop (pushing supply out and demand back) and prices continue to fall (pushing supply back and demand out). On balance, we assume that relative to point B, demand shifts out as does supply. We move to C. Over the entire duration, the dollar has depreciated, with little change after the initial depreciation from A to B. In the goods market, income falls (shifting out NX and shifting back savings minus investment) and the real exchange rate falls (shifting out NX relative to its depressed position given the drop in For Y ). We move to point B, consistent with the drop in real interest rates. In the long-run, income returns to its original value (shifting NX back and returning us to the original savings minus investment) and the real exchange rate continues to fall with the drop in prices (shifting NX out). We assume that the changes in NX cancel out. This does not have to be the case, but it must be the case that point C is below point B.
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