HW7_sol - Chapter 12 Aggregate Demand in the Open Economy...

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5. In the text, we assumed that net exports depend only on the exchange rate. This is analo- gous to the usual story in microeconomics in which the demand for any good (in this case, net exports) depends on the price of that good. The “price” of net exports is the exchange rate. However, we also expect that the demand for any good depends on income, and this may be true here as well: as income rises, we want to buy more of all goods, both domestic and imported. Hence, as income rises, imports increase, so net exports fall. Thus, we can write net exports as a function of both the exchange rate and income: NX = NX ( e , Y ). Figure 12–19 shows the net exports schedule as a function of the exchange rate. As before, the net exports schedule is downward sloping, so an increase in the exchange rate reduces net exports. We have drawn this schedule for a given level of income. If income increases from Y 1 to Y 2 , the net exports schedule shifts inward from NX ( Y 1 ) to NX ( Y 2 ). a. Figure 12–20 shows the effect of a fiscal expansion under floating exchange rates. The fiscal expansion (an increase in government expenditure or a cut in taxes) shifts the IS * schedule to the right. But with floating exchange rates, if the LM * curve does not change, neither does income. Since income does not change, the net-exports schedule remains at its original level NX ( Y 1 ).
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