Problem Set _6 ANSWERS

Problem Set _6 ANSWERS - B. Answer BOTH of the following...

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Problem Set #6 4/10 B. Answer BOTH of the following questions based on the standard models of analysis developed in class. 1. Open Economy IS-LM Model with the Foreign Exchange Market (35 points). Argentina and Brazil are major trading partners that are initially in general equilibrium with flexible exchange rates. a. Based only on this information, use an open economy IS – LM model diagram for each country, as well as a diagram of the foreign exchange market for the Argentine peso, to clearly and accurately show each economy’s initial equilibrium position and equilibrium in the foreign exchange market. These diagrams should be shown in BLACK. Foreign Exchange Market IS 1 Argentina Brazil r r 1 r 0 r r 0 r 1 Y 1 Y 0 Y Y 1 Y 0 Y IS 0 LM 0 LM 1 LM 0 IS 0 S 0 D 0 Q Peso P Peso P 2 P 0 S 1 D 1 S 2
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Problem Set #6 5/10 b. Provide a brief economic explanation of what you have drawn in your diagrams above. Both Argentina and Brazil are initially in short-term equilibrium with economic output at Y 0 and with the real interest rate at r 0 in their respective diagrams. The exchange rate is also in equilibrium at P 0 .
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Problem Set #6 6/10 c. Now suppose that the Argentine central bank conducts a contractionary monetary policy. On your diagrams above, clearly and accurately show what happens to economic output and the real interest rate in both Argentina and Brazil and to the Argentine peso exchange rate. These changes should be drawn in RED . d. Provide a brief economic explanation for the changes you showed in your diagrams above. Be sure to describe the adjustment process that the economy undergoes with respect to economic output, the real interest rate, the exchange rate, and net exports and explain why these changes take place. Argentina’s contractionary monetary policy shifts its LM curve to the left from LM 0 to LM 1 . This causes the real interest rate to increase from r 0 to r 1 . The increase in the real interest rate reduces interest-sensitive spending and economic output falls from Y 0 to Y 1 . The decrease in Argentina’s economic output from Y 0 to Y 1 also reduces Argentina’s imports and, therefore, increases its net exports. A decrease in imports causes a reduction in the supply of Argentine pesos in the foreign exchange market, shifting the supply curve to the left from S 0 to S 1 . The increase in Argentina’s real interest rate from r 0 to r 1 increases the demand for Argentine peso in the foreign exchange market because it increases foreign capital inflows. This shifts the demand curve to the right from D 0 to D 1 . The higher real interest rate also decreases the supply of Argentine peso in the foreign
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Problem Set _6 ANSWERS - B. Answer BOTH of the following...

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