My P Le
EC224
Problem Set 5
1.
a. A reduction in foreign output decreases foreign income, thus reduces foreign demand for
domestic goods. As total demand for domestic goods decreases, IS curve shift to the left
decreasing both domestic output and interest rate, and exports decreases, net export decreases, so
the net export line shifts down by ∆X.
When the IS curve shifts in, the domestic interest rate falls below the foreign interest rate leading
to an outflow of money (as domestic bonds appear less attractive than foreign bonds, so demand
for foreign currency goes up, central bank sell domestic currency to buy foreign currency). This
outflow ofmoney causes the money supply to decrease, shifting the LM curve up. The domestic
interest rate goes up instantly to clear the market. As interest rate increases, investment decreases
and output decreases over time. As interest rate increases back to its original level, the original
fixed exchange rate is maintained. As exchange rate rises back to its original level, domestic
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- Spring '11
- DianneLabert
- Microeconomics, Macroeconomics, International Trade, 10%, domestic goods
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