Econ 434: International Finance and Open Economy Macroeconomics

Econ 434: International Finance and Open Economy Macroeconomics

Econ 434 – International Finance and Open Economy Macroeconomics

Subject: Economics    / General Economics
Question
Homework Four
Econ 434: International Finance and Open Economy Macroeconomics

Suppose that Home is in long-run full employment equilibrium when it is hit by a consumer
confidence crisis (shift in the consumption function). Use the IS-LM-FX model to answer the
following questions. Assume that home has a floating exchange rate. Use diagrams where
appropriate.
1. Show how the consumption shock affects the interest rate, the exchange rate, and
output.
2. Explain how the consumption shock affects the country’s trade balance.
3. Suppose that you have unopposed executive power. How could you use fiscal policy to
maintain full employment in the face of the consumption shock? How would your policy
affect the interest rate, the exchange rate, and exports relative to their state without
fiscal policy?
4. Now suppose that you are appointed to be central bank head. What would be the
appropriate change in monetary policy in the face of the consumption shock? How
would this monetary policy affect the interest rate, the exchange rate, and exports?
5. Suppose now that foreign demand for Home’s output were to fall. How would this
shock affect consumption and interest rates in Home?
Now suppose instead that Home has a fixed exchange rate. Suppose that the government
raises taxes when the economy is initially in full employment.
6. How do higher taxes affect investment, consumption, and the trade balance in Home?
7. Suppose that the central bank were to increase the money supply. What is the impact of
the increase in money supply on interest rates and output in Home?