PS12 - Problem Set # 12 Solutions Chapter 12 #4 a) A...

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Problem Set # 12 Solutions Chapter 12 #4 a) A depreciation of the currency makes American goods more competitive. This is because a depreciation means that the same price in dollars translates into fewer units of foreign currency. That is, in terms of the foreign currency, American goods become cheaper so that foreigners buy more of them. For example, suppose that the exchange rate between yen and dollars falls from 200 yen/dollar to 100 yen/dollar. If an American can of tennis balls costs \$2.50, its price in yen falls from 500 yen to 250 yen. This fall in price increases the quantity of American-made tennis balls demanded in Japan. That is, American tennis balls are more competitive. b) Consider first the case of floating exchange rates. We know that the position of the LM curve determines output (is ‘superpotent’ for floaters with capital mobility). Hence, we know that we want to keep the money supply fixed. As shown in the figure below, we want to use fiscal policy to shift the IS curve to the left to cause the exchange rate to fall (depreciate). We can do this by reducing government spending or increasing taxes. Using the model from class: Fiscal contraction shifts the IS curve to the left. At β , i’<i* inducing capital outflows. The decreased demand for the domestic currency depreciates the real exchange rate ( ε falls). The real depreciation makes domestic goods more competitive, increasing exports and increasing net exports. This causes the IS curve to shift back until the current account and capital account are back in balance, at α . Here, we are back to are original level of Y e , but the exchange rate has been depreciated as desired. Now suppose that the exchange rate is fixed. If we want to increase competitiveness, we need to

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This note was uploaded on 10/25/2010 for the course MBA GloEco taught by Professor N.m. during the Spring '10 term at Institute of Business Administration.

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PS12 - Problem Set # 12 Solutions Chapter 12 #4 a) A...

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