Introductory Macroeconomics, Hilary Term 2023

Problem Set 8

1. Use the Mundell-Fleming model to predict the effects on aggregate income, the exchange rate, and the trade balance of the following shocks. Give answers under both fixed and floating exchange rates.
   
   
   1. A fall in consumer confidence induces households to spend less and save more
   
   
   2. The introduction of a stylish line of Toyotas makes some consumers prefer foreign to domestic cars.
   
   
   3. The introduction of automatic teller machines reduces the demand for money.
   
   Mankiw & Taylor, Q1, p. 384.
   
   
2. Even in an integrated world capital market an open economy's interest rate can differ from the 'world rate' for periods of time. If the currency is overvalued relative to expectations of its long-run value, arbitrageurs will not want to hold a country's assets for fear of the loss they will suffer when the currency depreciates. Unless they are compensated with a higher rate of interest, of course. So the interest rate can rise above the world average if the exchange rate rises; symmetrically interest rates can fall below world rates if the currency falls below its long-run value. This can be summed up with a simple upward sloping curve relating the domestic interest rate and the exchange rate.
   
   With net exports a negative function of the exchange rate, the IS curve has an additional reason to slope downwards. Not only are interest-sensitive components of domestic demand reduced by high interest; now net exports too are reduced as higher interest rates cause the currency to appreciate.
   
   Use diagrams to analyse the effects on the important macroeconomic variables of the following changes, for an economy with a flexible exchange rate:
   
   
   1. A rise in foreign income.
   
   
   2. An increase in saving in the rest of the world that causes the 'world interest rate' to fall.
   
   
   3. The imposition of austerity policies (a fiscal contraction) at home.
   
   Blanchard & Johnson, Ch. 20 could be useful if you get stuck on this one.
   
   Optional
   
   
3. Consider a small open economy with perfectly flexible wages and prices, and competitive markets. What will happen to the trade balance and the real exchange rate when government purchases increase, such as during a war? Does your answer depend on whether this is a local war or a world war? Mankiw & Taylor, Q5, p. 169.