12Chapter-Mankiw

12Chapter-Mankiw - CHAPTER 12 Aggregate Demand in the Open...

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Questions for Review 1. In the Mundell–Fleming model, an increase in taxes shifts the IS * curve to the left. If the exchange rate floats freely, then the LM * curve is unaffected. As shown in Figure 12–1, the exchange rate falls while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase. 111 A B Y Income, output e Exchange rate IS 2 * * IS 1 LM * Figure 12–1 CHAPTER 12 Aggregate Demand in the Open Economy
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Now suppose there are fixed exchange rates. When the IS * curve shifts to the left in Figure 12–2, the money supply has to fall to keep the exchange rate constant, shift- ing the LM * curve from LM to LM . As shown in the figure, output falls while the exchange rate remains fixed. Net exports can only change if the exchange rate changes or the net exports sched- ule shifts. Neither occurs here, so net exports do not change. We conclude that in an open economy, fiscal policy is effective at influencing out- put under fixed exchange rates but ineffective under floating exchange rates. 2. In the Mundell–Fleming model with floating exchange rates, a reduction in the money supply reduces real balances M/P , causing the LM * curve to shift to the left. As shown in Figure 12–3, this leads to a new equilibrium with lower income and a higher exchange rate. The increase in the exchange rate reduces the trade balance. 112 Answers to Textbook Questions and Problems * 1 * 2 A B Y e e Exchange rate Fixed exchange rate IS 2 IS 1 Income, output Y 1 LM 2 LM 1 ** Y 2 * * Figure 12–2 e B A Y Income, output LM 2 LM 1 IS * Y 1 Y 2 Figure 12–3
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If exchange rates are fixed, then the upward pressure on the exchange rate forces the Fed to sell dollars and buy foreign exchange. This increases the money supply M and shifts the LM * curve back to the right until it reaches LM again, as shown in Figure 12–4. In equilibrium, income, the exchange rate, and the trade balance are unchanged. We conclude that in an open economy, monetary policy is effective at influencing output under floating exchange rates but impossible under fixed exchange rates. 3. In the Mundell–Fleming model under floating exchange rates, removing a quota on imported cars shifts the net exports schedule inward, as shown in Figure 12–5. As in the figure, for any given exchange rate, such as e , net exports fall. This is because it now becomes possible for Americans to buy more Toyotas, Volkswagens, and other for- eign cars than they could when there was a quota. Chapter 12 Aggregate Demand in the Open Economy 113 * 1 e Exchange rate Fixed exchange rate A Y Income, output LM 1 IS * * e Figure 12–4 e e NX Net exports NX 1 ( e ) NX 2 ( e ) NX 1 NX 2 Figure 12–5
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This inward shift in the net-exports schedule causes the IS * schedule to shift inward as well, as shown in Figure 12–6.
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This note was uploaded on 02/22/2012 for the course ECON 602 taught by Professor Smith during the Spring '12 term at FSU.

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12Chapter-Mankiw - CHAPTER 12 Aggregate Demand in the Open...

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