# Ch. 9 - ECN101 Intermediate Macroeconomics Professor...

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ECN101 Intermediate Macroeconomics Winter 2009 Professor E.A.Frenkel Homework 9-Solutions (1). You are boss of a small open economy that is operating at less than full employment. You have a FIXED EXCHANGE RATE regime. You have an inefficient legislature so that fiscal policy is not available. You want to use monetary policy. According to the Mundell-Fleming model (IS* - LM*), what problems do you face if you try to use monetary policy (expanding the money supply)? Why? What alternatives are open to you? Solution: Under fixed exchange rates, if you try to use monetary policy, for example, expanding money supply by buying bonds from the public, it will put downward pressure on the exchange rate. To maintain the fixed exchange rate, the money supply and the LM curve must return to their initial positions. Hence, under fixed exchange rate, normal monetary policy is ineffective. This economy, however, can conduct a type of policy: it can decide to reduce the level at which the exchange rate is fixed, that is, devaluate its currency from 1 e to 2 e . The devaluation shifts the LM* curve to the right; it acts like an increase in the money supply under a floating exchange rate. As the currency depreciates, the exports rise, so does the aggregate income. Figure 1 (2). Using the Mundell-Fleming model trace through the impact of a sudden rise in the price level (say from an "adverse" supply shock) on the flexible equilibrium real exchange rate and level of GDP. Now translate this impact onto the AS-AD diagram (with a horizontal SRAS curve). In the "long run" what would happen in the IS* - LM* diagram. Why? Excahnge rate, e Y B A 2 e Income, Y IS * LM * under Fixed at 2 e LM * under 1 e

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Solution: In the Mudell-Fleming model, a sudden rise in the price level decrease the supply of real balances, (M/P) s . As shown in panel (a) of Figure 2, the LM* shifts to the left, causing real exchange rate to rise, as real exchange rate increases, domestic goods become less competitive, net exports decreases and therefore output falls below the full employment level, i.e. the economy moves from point A to point B. In the AS-AD diagram, the short run aggregate supply curve shifts up upon the adverse supply, the price level rises and output falls. In the long run, however, low demand causes prices and wages to fall gradually back to the original level, economy returns from point B to point A. In the IS*-LM* graph, as price returns to P 1 , LM* curve shifts back , restoring the output level, and moving the economy back to point A. e r1 e r2 Real exchange rate, e r LM * (P 2 ) A B A B Y Y P 1 P 2 Price level, P Y LRAS IS Y LM * (P 1 ) SRAS 1 SRAS 2 (a) The Mundell-Fleming Model Figure 2 (b) The AD-AS Model (3). This is more difficult: An open economy suddenly faces a massive strike and rioting by workers in a major export industry. The "risk premium" shoots up. Can you trace through a plausible scenario of macro-economic impacts to this economy using the IS*- LM* diagram. Can you suggest a policy or policies that would solve the problem, and
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Ch. 9 - ECN101 Intermediate Macroeconomics Professor...

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