Suggested Solutions to Assignment 2 - Department of Economics

So, the general equilibrium value of the real interest rate is 19%.
With r = 0.19 and Y = 1000, the LM curve (Eq. (6)) gives
924
0 .19 = − +
200P
924
⇒ = 2.5 − 0.19
200P
924
⇒ P = = 2
200* 2.31
5
( 1000)
2000
So, the general equilibrium value of the price level is 2.
The general equilibrium value of net exports,
NX = 170- 0.08*1000-0.5*230= 170 – 80 – 115 = –25.
The general equilibrium value of consumption,
C= 200 + 0.6(1000 – 20-0.2*1000) – 200*0.19 = 630
The general equilibrium value of investment, / = 300 – 300*0.19 = 243
Figure 4(c) illustrates the general equilibrium values of output and the real interest rate in
the IS-LM-FE diagram.
d) Starting from the initial general equilibrium, money supply is increased to
1024. Assuming flexible exchange rates, what are the effects of this change on
output, the real interest rate, the real exchange rate, consumption,
investment, and net exports in the short run? Illustrate the short-run
equilibrium values of output and the real interest rate in the IS-LM-FE
diagram.
Start at the general equilibrium derived in part (c), where the general equilibrium real
interest rate is 19%. So, by assumption, the foreign interest rate is fixed at 19% and the
domestic real interest rate does not deviate from this level. That is, r = 0.19 holds at any
short run or long-run equilibrium.
Page 4 of 7 Pages