Answers the rise in the domestic real interest rate

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Answers: The rise in the domestic real interest rate leads to a rise in the demand for domestic assets, raising the exchange rate. The rise in the exchange rate reduces domestic net exports and raises foreign net exports. Level of difficulty: 2 Section: 13.2 6. Describe the effects of contractionary fiscal policy by the domestic government on output, the real interest rate, and net exports in both the domestic and foreign country, using a Keynesian model. Answers: Domestic country: output falls, real interest rate falls, and net exports rise. Foreign country: output falls, real interest rate falls, and net exports fall. Level of difficulty: 2 Section: 13.4 7. Describe the effects of contractionary monetary policy by the domestic central bank on output, the real interest rate, and net exports in both the domestic and foreign country, using a Keynesian model in the short run. What happens in the long run? Answers: Domestic country: output falls, real interest rate rises, and net exports rise. Foreign country: output falls, real interest rate falls, and net exports fall. There are no real effects in the long run. Level of difficulty: 2 Section: 13.4
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Chapter 13 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 215 8. A classical economy is described by the equations AD : Y = 1000 + 100 M/P AS : Y = 1500 The real exchange rate is 3 bushels/bottle, the domestic nominal money supply is 30 florins, and the foreign price level is 8 crowns/bushel. (a) What is the nominal exchange rate? (b) If the government wants to maintain an official nominal exchange rate of 6 crowns/florin, what must the nominal money supply be? Answers: (a) 4 crowns/florin (b) 20 florins Level of difficulty: 2 Section: 13.5 9. (a) What happens to the fundamental value of a country’s exchange rate when it raises its money supply in a fixed-exchange-rate system? Does this make the currency overvalued or undervalued if originally the official rate equaled the fundamental value? (b) What happens to the fundamental value of a country’s exchange rate when the foreign country raises its money supply? Does this make the currency overvalued or undervalued if originally the official rate equaled the fundamental value? (c) So, if a country wants to maintain its official rate equal to its fundamental value, what must it do when the foreign country raises its money supply? What happens to inflation? Answers: (a) Fundamental value falls below the official rate, so the currency is overvalued. (b) Fundamental value increases above the official rate, so the currency is undervalued. (c) The country must raise its money supply. This leads to inflation worldwide. Level of difficulty: 3 Section: 13.5 10. Describe how the euro was created. What are the benefits of the monetary union? What are the costs? Answers: The European countries unified their currencies to reduce the costs of trading goods and assets. This is beneficial as it reduces transactions costs and because the European economy would rival that of the United States in scope and wealth. The potential costs are that there may be political conflict if countries disagree about monetary policy, or if inflation isn’t as stable or low as some countries desire. Level of difficulty: 1 Section: 13.5
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