Suggested Solutions to Assignment 2 - Department of Economics

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(ii) During the following year, Home has 10% domestic inflation and Foreign has 20% domestic inflation. The real exchange rate remains unchanged. At the end of the year, what has happened to the nominal exchange rate? Which country has had a nominal appreciation? Which has a nominal depreciation? Inflation in Home is π H = 10%. Inflation in Foreign is π F = 20%. The real exchange rate is constant. We can write Eq. (2) in the percentage change form as ∆e e nom nom = ∆e ∆P + e P F F ∆P − P = ∆e + π F − π e H (3) ∆enom So, = 0 + 0.20 − 0.10 = 0. 10 . e nom Therefore, the nominal exchange rate (yens per dollar) has increased by 10%. The Home dollar has appreciated, the Foreign yen has depreciated. B2. (20 marks) Consider the following Keynesian small open economy: Desired Consumption: C d = 200 + 0.6( Y − T ) − 200r Desired Investment: I d = 300 − 300r Government Purchases: G = 152 Taxes: T = 20 + 0. 2Y Net Exports: NX = 170 − 0.08Y − 0. 5e Real exchange rate: e = 230 Real Money Demand: L = 0.5Y − 200r Money Supply M = 924 Full-employment output: Y = 1000 Net Factor Payments: NFP = 0 In this economy, the real interest rate does not deviate from the foreign interest rate. a) Derive the equation for the IS curve as a function of Y and e. The equation for the IS curve is derived from the goods market equilibrium condition for an open economy, which is S d d − I = CA = NX + NFP = NX (because, NFP=0). (1) Page 2 of 7 Pages
S d = Y+NFP - C d - G = Y+0 – {200 + 0.6[Y – (20 + 0.2Y)] – 200r} –152 = 0.52Y – 340 +200r So, S d = 0.52Y – 340 +200r (2) It is given that NX = 170 − 0.08Y − 0. 5e and I d = 300 − 300r . Substituting the functional forms of S d , d I , and NX into Eq. (1), 0.52Y – 340 + 200r – (300 – 300r) = 170 – 0.08Y –0.5e. Rearranging terms and simplifying gives the IS curve: 500r = 810 – 0.5e – 0.6Y 810 5 6 or, r = − e − Y 500 5000 5000 (4) [IS curve] b) Derive the equation for the LM curve as a function of Y, M and P. The equation for the LM curve is derived from the assets market equilibrium condition for an open economy, which is M/P = L (5) Substituting the given functional form of L into Eq. (5), or, or, M/P = 0.5Y – 200r 200r = -M/P +0.5Y M 5 r = − Y 200 P 2000 (6) [LM curve] c) What are the general equilibrium (that is, long-run) values of output, the real interest rate, real exchange rate, consumption, investment, net exports, and the price level? Illustrate the general equilibrium values of output and the real interest rate in the IS-LM-FE diagram. In the general equilibrium, output equals to its full-employment level, which is 1000. The given general equilibrium value of real exchange rate, e = 230. With e = 230 and Y = 1000, the IS curve (Eq. (4)) gives r = 810 500 − 5 5000 6 5000 ( 230) − ( 1000) = 0. 19 Page 3 of 7 Pages
Page 1: ECON 2450 Intermediate Macroeconomi
Page 5 and 6: In the short run, the price level r
Page 7: The new general equilibrium value o

Suggested Solutions to Assignment 2 - Department of Economics

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