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# solution_ps7 - EC 315 Problem set 7 Solutions Ex 1 see...

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EC 315 - Problem set 7 Solutions Ex 1) see figures 1) - Let’s suppose a negative shock in country A. This means that the IS for this country will shift down. The interest rate in country A is now too low, this will cause a depreciation of the currency vis à vis country B. This will have two real effects. It will push the economy in A, via exports to country B and, by the other way round effect, will reduce exports of country B. The final equilibrium is restored when the new interest rate is equal in both countries. The interest rate in the region will be lower, and the shock will be absorbed partially by country B as well. Note that we allow in the new equilibrium the interest rate in the region to be lower because we leave apart the rest of the world. Alternatively we could think that the region is big with respect the rest of the world or sufficiently isolated. - In the case of fixed exchange rate, the adjustment process pass through the money supply adjustments. Country A will be experiencing a lower interest rate, this will imply a decrease in the foreign reserves, and therefore the money supply to be reduced. The LM curve in this country shift up. The opposite mechanism will be at work in country B. The total effect will be a worsening of the real effects of the shock in terms of output on country A, and an expansionary effect in terms of output (because of the decrease in the interest rate) in country B. We are assuming fixed prices, so we do not need to worry about possible inflationary pressure on country B. 2) - In this case we have to look at the effects of a symmetric shock. Given the assumptions that the two countries are symmetric, and that the shock is perfectly symmetric, the new equilibrium following the exchange rate adjustment in the floating regime is going to be the same as the initial one. On impact following the shock, the IS in country A shifts down, while in country B the IS curve will shift up. The spread between the two interest rate will put pressure on the exchange rate, that will tend to depreciate (from country’s A perspective). This implies that country A will be now more competitive with respect to country B. Because of the real effects induced by the depreciation of the exchange rate

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