PS4 - My P. Le EC224 Problem Set 4 1. a. A decrease in the...

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My P. Le EC224 Problem Set 4 1. a. A decrease in the money supply leads to an increase in the domestic interest rate: LM shifts up to LM1. The IS curve is unchanged. Immediately, the economy moves from A to A’ to clear the market, then gradually moves to A1. Interest rate goes up, investment goes down and output goes down. The increase in domestic interest rate makes domestic bonds more attractive, leading to an appreciation. The higher interest rate and the appreciation (which makes domestic goods more expensive than foreign goods) both decrease the domestic demand for goods. The appreciation increases import and decreases exports, while the decrease in output decreases import. Let’s assume that import increases/ or import decreases less than export – thus if trade is initially balance, the money contraction will lead to a trade deficit. c. If Marshall-Lerner condition does not hold, the appreciation will lead to a trade surplus – as the effect of domestic goods becoming relatively more expensive (that decreases X and increases IM) is offset by the decrease in the price of imports. As NX increases, the ZZ line shifts up by the change in NX, and NX line shifts up by the change in NX. As the price of imports decreases, people buying imports will be financially better off, thus their demand goes up which by the multiplier increases output. This increase in output may
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This note was uploaded on 10/27/2011 for the course ECON 125 taught by Professor Diannelabert during the Spring '11 term at Hamilton College.

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PS4 - My P. Le EC224 Problem Set 4 1. a. A decrease in the...

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