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1 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... COURSES > BA121 > CONTROL PANEL > POOL MANAGER > POOL CANVAS Add, modify, and remove questions. Select a question type from the Add drop-down list and click Go to add questions. Use Creation Settings to establish which default options, such as feedback and images, are available for question creation. Add Creation Settings Name TestBanks Chapter 13 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime Description Instructions Compared to a closed economy, an open economy is one that: allows the exchange rate to float. fixes the exchange rate. trades with other countries. does not trade with other countries. The Mundell Fleming model assumes that: prices are flexible, whereas the IS LM model assumes that prices are fixed. prices are fixed, whereas the IS LM model assumes that prices are flexible. as in the IS LM model, prices are fixed. as in the IS LM model, prices are flexible. The Mundell Fleming model is a model for a open economy. short-run; small short-run; large long-run; large long-run; small In the Mundell Fleming model: the exchange rate system must have a floating exchange rate. the exchange rate system must have a fixed exchange rate. it makes no difference whether the exchange rate system has a floating or a fixed exchange rate. the behavior of the economy depends on whether the exchange rate system has a floating or fixed exchange rate. In the Mundell Fleming model, the domestic interest rate is determined by the: intersection of the LM and IS curves. domestic rate of inflation. world rate of inflation. world interest rate. 1 of 27 12/8/ :42

2 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In a small open economy with perfect capital mobility, if the domestic interest rate were to rise above the world interest rate, then would drive the domestic interest rate back to the level of the world interest rate. capital inflow capital outflow the central bank a decline in domestic saving Assuming there is perfect capital mobility, compared to a large open economy, a small open economy is one in which the: exchange rate is fixed. exchange rate is floating. domestic interest rate equals the world interest rate. domestic interest rate is not equal to the world interest rate. In a small open economy a decrease in the exchange rate will net exports and shift the curve. increase; IS decrease; IS increase; LM decrease; LM If short-run equilibrium in the Mundell Fleming model is represented by a graph with Y along the horizontal axis and * the exchange rate along the vertical axis, then the IS curve: slopes downward and to the right because the higher the exchange rate, the lower the level of net exports and, therefore, of short-run equilibrium income in the goods market. is vertical because there is only one investment level that is consistent with the world interest rate. * is vertical because the exchange rate does not enter into the IS equation. slopes downward and to the right because the higher the exchange rate, the higher the level of net exports and, therefore, of short-run equilibrium income in the goods market. * * In the Mundell Fleming model on a Y e graph, the curves labeled IS and LM are labeled that way as a reminder that: the price level is held constant at the world price level p*. the interest rate is held constant at the world interest rate r*. the exchange rate is held constant at the world exchange rate e*. output is held constant at the full employment level. If short-run equilibrium in the Mundell Fleming model is represented by a graph with Y along the horizontal axis and * the exchange rate along the vertical axis, then the LM curve: slopes upward and to the right because at a higher income a higher interest rate is needed to increase velocity. is vertical because monetary velocity is independent of the interest rate. * is vertical because the exchange rate does not enter into the LM equation. slopes upward and to the right because a higher exchange rate leads to a higher income. 2 of 27 12/8/ :42

3 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In the Mundell Fleming model, the exogenous variables are the: world interest rate, the price level, and the exchange rate. level of government spending, taxes, and income. exchange rate and level of income. price level, world interest rate, monetary policy, and fiscal policy. * * The intersection of the IS and LM curves shows the and the at which both the goods market and the money market are in equilibrium. interest rate; price level price level; exchange rate level of output; exchange rate level of output; price level Under a floating system, the exchange rate: fluctuates in response to changing economic conditions. is maintained at a predetermined level by the central bank. is changed at regular intervals by the central bank. fluctuates in response to changes in the price of gold. In a small open economy with a floating exchange rate, an effective policy to increase equilibrium output is to: increase government spending. increase taxes. increase the money supply. decrease the money supply. In a small open economy with a floating exchange rate, an effective policy to decrease equilibrium output is to: decrease government spending. decrease taxes. increase the money supply. decrease the money supply. In a small open economy with a floating exchange rate, the exchange rate will appreciate if: the money supply is increased. the money supply is decreased. government spending is decreased. taxes are increased. 3 of 27 12/8/ :42

4 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In a small open economy with a floating exchange rate, the exchange rate will depreciate if: the money supply is decreased. import quotas are imposed. government spending is increased. taxes are decreased. In a small open economy with a floating exchange rate, if the government adopts an expansionary fiscal policy, in the new short-run equilibrium: income and the exchange rate will both rise. the exchange rate will rise, but income will remain unchanged. income will rise, but the exchange rate will remain unchanged. both income and the interest rate will rise. In a small open economy with a floating exchange rate, a rise in government spending in the new short-run equilibrium: chokes off investment, but not by as much as the new government spending. chokes off an amount of investment just equal to the new government spending. attracts foreign capital, thus raising the exchange rate and reducing net exports, but not by as much as the new government spending. attracts foreign capital, thus raising the exchange rate and reducing net exports by an amount just equal to the new government spending. In a small open economy with a floating exchange rate, the supply of real money balances is fixed and a rise in government spending: raises the interest rate, so that income must rise to maintain equilibrium in the money market. raises the interest rate so that net exports must fall to maintain equilibrium in the goods market. cannot change the interest rate so that net exports must fall to maintain equilibrium in the goods market. cannot change the interest rate so income must rise to maintain equilibrium in the money market. Exhibit: IS* LM* Reference: Ref 13-1 (Exhibit: IS* LM*) A small open economy with a floating exchange rate is initially at equilibrium A with IS*, LM*, 1 1 equilibrium exchange rate e, and equilibrium output Y. If there is an increase in government spending to IS*, the new equilibrium will be at, holding everything else constant. 4 of 27 12/8/ :42

5 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... A B C D Exhibit: IS* LM* Reference: Ref 13-1 (Exhibit: IS* LM*) A small open economy with a floating exchange rate is initially at equilibrium A with equilibrium exchange rate e, and equilibrium output Y. If there is a monetary expansion to 2 1 the new equilibrium will be at, holding everything else constant. A B C D In a small open economy with a floating exchange rate, if the government decreases the money supply, then in the new short-run equilibrium: income falls and the exchange rate rises. the exchange rate falls and income rises. income remains unchanged but the exchange rate rises. the exchange rate remains unchanged but income falls. In a small open economy with a floating exchange rate, if the government increases the money supply, then in the new short-run equilibrium the: interest rate falls and the level of investment rises. exchange rate falls and net exports increase. interest rate falls but the level of investment does not rise. exchange rate falls but net exports do not increase. According to the Mundell Fleming model for a small open economy with flexible exchange rates, if the Federal Reserve cannot alter domestic interest rates, changes in the money supply could still influence aggregate income through changes in the: exchange rate. price level. level of government spending. 5 of 27 12/8/ :42

6 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... tax rates. In a small open economy with a floating exchange rate, if the government imposes an import quota, then in the new * short-run equilibrium the IS curve shifts to the right, raising the exchange rate: but not raising net exports or income. and net exports but not income. and income but not net exports. net exports and income. In a small open economy with a floating exchange rate, if the government imposes a tariff on foreign goods, then in the new short-run equilibrium: imports will decrease while exports remain constant, leading to a rise in net exports. imports will decrease and exports will increase, leading to a rise in net exports. imports will decrease and exports will decrease by an equal amount. both imports and exports will remain unchanged. Exhibit: Shifting IS* and LM* Reference: Ref 13-2 (Exhibit: Shifting IS* and LM*) A small open economy with a floating exchange rate is initially in equilibrium at A with Holding all else constant, if the government imposes a tariff on imports in order to protect domestic jobs, then the curve will shift to. LM*; LM*; IS*; IS*; Exhibit: Shifting IS* and LM* 6 of 27 12/8/ :42

7 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... Reference: Ref 13-2 (Exhibit: Shifting IS* and LM*) A small open economy with a floating exchange rate is initially in equilibrium at A with Holding all else constant, if domestic consumers develop greater preferences for imported goods, then the curve will shift to. LM*; LM*; IS*; IS*; Under a fixed system, the exchange rate: fluctuates in response to changing economic conditions. is maintained at a predetermined level by the central bank. is changed at regular intervals by the central bank. fluctuates in response to changes in the price of gold. To maintain a fixed-exchange-rate system, if the exchange rate moves below the fixed-exchange-rate level, then the central bank must: buy foreign currency. sell foreign currency from reserves. raise taxes. decrease government spending. If the Fed announced it would fix the exchange rate at 100 yen per dollar, but with the current money supply the equilibrium exchange rate was 150 yen per dollar, then: arbitrageurs would sell yen in the marketplace. arbitrageurs would buy yen from the Fed. the money supply would fall until the market exchange rate was 100 yen per dollar. the money supply would rise until the market exchange rate was 100 yen per dollar. Under a fixed-exchange-rate system, the central bank of a small open economy must: have a reserve of its own currency, which it must have accumulated in past transactions. have a reserve of foreign currency, which it can print. 7 of 27 12/8/ :42

8 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... allow the money supply to adjust to whatever level will ensure that the equilibrium exchange rate equals the announced exchange rate. follow a rule specifying a constant growth rate for the money supply. If there is a fixed-exchange-rate system, then in the short run described by the Mundell Fleming model: the nominal exchange rate is fixed, but the real exchange rate is free to vary. the real exchange rate is fixed, but the nominal exchange rate is free to vary. both the nominal and real exchange rates are fixed. the nominal exchange rate is fixed, but whether the real exchange rate is fixed depends on whether the central bank follows a rule of constant growth of the money supply. If there is a fixed-exchange-rate system, then in the long run: the nominal exchange rate is fixed, but the real exchange rate is free to vary. the real exchange rate is fixed, but the nominal exchange rate is free to vary. both the nominal and real exchange rates are fixed. the nominal and real exchange rates vary by a fixed amount. During the era of the gold standard, the price of gold in England: was always equal to the price of gold in the United States. was always a little higher than the price of gold in the United States, but it could not be higher by more than the cost of transporting gold from the United States to England. was always a little lower than the price of gold in the United States, but it could not be lower than the cost of transporting gold from England to the United States. could be higher or lower than the price of gold in the United States, but not by more than the cost of transporting gold between the two countries. In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the new short-run equilibrium: the exchange rate rises but income does not rise. income rises but the exchange rate does not rise. both income and the exchange rate rise. neither income nor the exchange rate rises, as the money supply contracts. In a small open economy with a fixed exchange rate, if the government increases government purchases, then in the process of adjusting to the new short-run equilibrium the money supply: increases to keep the exchange rate unchanged, thus augmenting the effect of government spending on income. decreases to keep the exchange rate unchanged, thus offsetting the effect of government spending on income. remains unchanged, and there is no effect of government spending on income. remains unchanged to keep the interest rate at the world interest rate, so that government spending reduces income. 8 of 27 12/8/ :42

9 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In a small open economy with a fixed exchange rate, an effective policy to increase equilibrium output is to: decrease government spending. decrease taxes. increase the money supply. decrease the money supply. Exhibit: IS* LM* Reference: Ref 13-3 (Exhibit: IS* LM*) A small open economy with a fixed exchange rate e is initially at equilibrium A with 2 and equilibrium output Y. If there is an increase in government spending to the new equilibrium will be at, 1 holding everything else constant. A B C D Exhibit: IS* LM* Reference: Ref 13-3 (Exhibit: IS* LM*) A small open economy with a fixed exchange rate e is initially at equilibrium A with 2 and equilibrium output Y. If there is a monetary expansion to 1 the new equilibrium will be at, holding everything else constant. A B C D 9 of 27 12/8/ :42

10 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In a small open economy with a fixed exchange rate, if the central bank tries to increase the money supply, then in the new short-run equilibrium: income rises. income falls. the exchange rate falls. income remains constant. In a small open economy with a fixed exchange rate, if the country devalues its currency, then in the new short-run equilibrium the exchange rate, and the LM* curve shifts to the. decreases; left increases; left decreases; right increases; right In the Mundell Fleming model with fixed exchange rates, attempts by the central bank to increase the money supply lead the exchange rate to fall, giving arbitrageurs the incentive to the central bank, which causes the money supply to. sell domestic currency to; increase sell domestic currency to; decrease buy domestic currency from; increase buy domestic currency from; decrease In the Mundell Fleming model with fixed exchange rates, attempts by the central bank to decrease the money supply: lead to a lower equilibrium level of income. lead to a higher equilibrium level of income. must be abandoned in order to maintain the fixed exchange rate. must be offset by expansionary fiscal policy. A revaluation of a currency under a fixed-exchange-rate system occurs when the level at which the currency is fixed is: increased. decreased. allowed to float. kept fixed within a band. A devaluation of a currency under a fixed-exchange-rate system occurs when the level at which the currency is fixed is: increased. decreased. allowed to float. kept fixed within a band. 10 of 27 12/8/ :42

11 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... During the Great Depression, countries that devalued their currencies generally whereas countries that maintained the old exchange rate. suffered longer; experienced no depression recovered relatively quickly; experienced no depression suffered longer; recovered relatively quickly recovered relatively quickly; suffered longer In a small open economy with a fixed exchange rate, if the government imposes an import quota, then net exports: decrease but the money supply falls and income falls. increase, the money supply increases, and income increases. are unchanged but the money supply falls and income falls. are unchanged, the money supply is unchanged, and income is unchanged. In the Mundell Fleming model with fixed exchange rates, the imposition of trade restrictions results in an increase in net exports because: investment increases. investment decreases. saving increases. saving decreases. According to the Mundell Fleming model, under: floating exchange rates, a monetary expansion raises income whereas a fiscal expansion does not, but under fixed exchange rates, a fiscal expansion raises income whereas a monetary expansion does not. both floating and fixed exchange rates, a monetary expansion raises income, but a fiscal expansion does not. both floating and fixed exchange rates, a fiscal expansion raises income, but a monetary expansion does not. floating exchange rates, a fiscal expansion raises income whereas a monetary expansion does not; but under a fixed exchange rate, a monetary expansion raises income whereas a fiscal expansion does not. According to the Mundell Fleming model, under floating exchange rates a fiscal expansion: lowers the exchange rate, but a monetary expansion raises it. raises the exchange rate, but a monetary expansion or an import restriction lowers it. or an import restriction lowers the exchange rate, but a monetary expansion raises it. or an import restriction raises the exchange rate, but a monetary expansion lowers it. According to the Mundell Fleming model, under fixed exchange rates expansionary fiscal policy causes income to, and under flexible exchange rates expansionary fiscal policy causes income to. increase; increase increase; remain unchanged remain unchanged; remain unchanged remain unchanged; increase 11 of 27 12/8/ :42

12 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... According to the Mundell Fleming model, in an economy with flexible exchange rates, expansionary fiscal policy causes the exchange rate to and expansionary monetary policy causes the exchange rate to. rise; rise rise; fall fall; fall fall; rise According to the Mundell Fleming model, in an economy with flexible exchange rates, expansionary fiscal policy causes net exports to, and expansionary monetary policy causes net exports to. increase; increase increase; decrease decrease; decrease decrease; increase According to the Mundell Fleming model, import restrictions in an economy with flexible exchange rates cause net exports to and in an economy with fixed exchange rates import restrictions cause net exports to. increase; increase increase; remain unchanged remain unchanged; remain unchanged remain unchanged; increase According to the Mundell Fleming model, under flexible exchange rates expansionary monetary policy increase income, and under fixed exchange rates expansionary monetary policy increase income. can; can can; cannot cannot; can cannot; cannot The risk premium included in the interest rate of small open economies incorporates: country risk and expectations of future exchange-rate changes. the law of one price. inefficient activity by arbitrageurs. capital mobility. Country risk included in the risk premium in interest rates refers to the: additional costs incurred when loans are made in currencies other than the domestic currency. possibility that loans in some countries may not be repaid because of political upheaval. expectation that the exchange rate may change in the future. potential change in the terms of trade between countries. 12 of 27 12/8/ :42

13 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... Exhibit: Risk Premium A small open economy with a floating exchange rate is initially in equilibrium at A with increase in the risk premium, then will shift to and If there is an will shift to. A small open economy with a floating exchange rate is initially in equilibrium at A with of a new government in the country decreases the risk premium, then will shift to and If the establishment will shift to. In order to compensate for an expected future decline in the Japanese yen relative to the U.S. dollar, the interest rate in Japan must be the interest rate in the United States. higher than lower than equal to fixed relative to In the Mundell Fleming model, if political turmoil raises the risk premium in a country's interest rate, then the exchange rate will. increase decrease remain constant either increase or decrease, depending on whether the IS* or LM* curve shifts more. In the Mundell Fleming model, expectations that a currency will lose value in the future will cause the current exchange rate to: 13 of 27 12/8/ :42

14 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... increase in the present. decrease in the present. remain constant in the present. decrease only in the future. An increase in income generated by an increase in the country risk premium will not occur if there is a(n) sufficient to offset the decline in the demand for money caused by the higher risk premium. decrease in the money supply increase in the money supply decrease in government spending fall in the price level An increase in income generated by an increase in the country risk premium will not occur if there is a(n) sufficient to offset the decline in the demand for money caused by the higher risk premium. increase in the money supply decrease in government spending increase in the price level caused by more expensive imports fall in the price level caused by less expensive imports According to the Mundell Fleming model with floating exchange rates, political uncertainty in Mexico in 1994 caused the risk premium on Mexican interest rates to and the Mexican exchange rate to. increase; increase increase; decrease decrease; increase decrease; decrease At the end of 1994 the Mexican government was unable to maintain a fixed exchange rate because it: ran out of foreign-currency reserves. was unable to increase the supply of Mexican pesos. was forced by the IMF to let the peso float. joined an exchange-rate union. Crony capitalism refers to situations in which banks make loans to those borrowers with the most: profitable investment projects. political clout. ability to repay the loans. creditworthy borrowers. One argument favoring a floating-exchange-rate system is that it: 14 of 27 12/8/ :42

15 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... makes international trade less difficult. minimizes destabilizing speculation by international investors. allows monetary policy to be used for other purposes. helps prevent excessive growth in the money supply. One argument favoring a fixed-exchange-rate system is that it: allows monetary policy to be used for stabilizing output and prices. reduces exchange-rate uncertainty, thereby promoting more international trade. leads to excessive growth of the money supply. requires no actions on the part of the central bank to implement. A monetary union with a common currency is an example of a: fixed-exchange-rate system. flexible-exchange-rate system. small open economy. large open economy. Some economists argue that monetary union will not work as well in Europe as it does in the United States for all of the following reasons except: labor is not as mobile in Europe as it is in the United States. there is no strong central government that can use fiscal policy in Europe as there is in the United States. there is no common language in Europe as there is in the United States. there is no European central bank as there is in the United States. If the exchange rate of currency A is fixed to a unit of currency B, then a potential problem for the central bank in charge of currency A is: running out of currency A. running out of currency B. generating excessive revenue from seigniorage. ineffective fiscal policy. A speculative attack on a currency occurs when: a central bank switches from a floating to a fixed exchange rate. investors' perceptions change, making a fixed exchange rate untenable. a country accepts dollarization. a central bank adopts a currency board to back the domestic currency with a foreign currency. A change in investors' perceptions that make a fixed exchange rate untenable is known as: a speculative attack. dollarization. seigniorage. 15 of 27 12/8/ :42

16 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... a floating currency board. An arrangement by which a central bank holds enough foreign currency to back each unit of the domestic currency is called a: floating exchange rate. dollarization. monetization. currency board. When a country abandons its national currency and adopts the currency of the United States, this is known as: a floating exchange rate system. dollarization. a speculative attack on the United States. a currency board. The principal economic loss when a country dollarizes is the loss of: seigniorage revenue. income tax revenue. monetary stability. a fixed exchange rate with the dollar. The impossible trinity refers to the idea that it is impossible for a country to simultaneously have: low inflation, low unemployment, and a rapid rate of GDP growth. free capital flows, a fixed exchange rate, and an independent monetary policy. high interest rates, a budget deficit, and a trade deficit. an expansionary fiscal policy, a contractionary monetary policy, and a flexible exchange rate. If a country chooses to have free capital flows and to conduct an independent monetary policy, then it must: live with exchange-rate volatility. restrict its citizens from participating in world financial markets. give up the use of monetary policy for purposes of domestic stabilization. have a fixed exchange rate. If a country chooses to have free capital flows and to maintain a fixed exchange rate, then it must: live with exchange-rate volatility. restrict its citizens from participating in world financial markets. give up the use of monetary policy for purposes of domestic stabilization. give up the use of fiscal policy for purposes of domestic stabilization. 16 of 27 12/8/ :42

17 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... If a country chooses to restrict international capital flows and to maintain a fixed exchange rate, then it must: live with exchange-rate volatility. control its citizens' access to world financial markets. give up the use of monetary policy for purposes of domestic stabilization. give up the use of fiscal policy for purposes of domestic stabilization. Between 1995 and 2005, China chose to: conduct independent monetary policy, allow free international-capital flows, and maintain a fixed exchange rate. maintain a fixed exchange rate, allow free international-capital flows, and give up the use of monetary policy for domestic stabilization. conduct an independent monetary policy, restrict international-capital flows, and maintain a fixed exchange rate. allow a flexible exchange rate, conduct an independent monetary policy, and allow free internationalcapital flows. Which of the following would be evidence that a country with a fixed exchange rate has an undervalued currency? The government has a budget surplus. The government has a budget deficit. The central bank's foreign-currency reserves are increasing. The central bank's foreign-currency reserves are decreasing. In the Mundell Fleming model, if the price level falls, then the equilibrium income rises and the real exchange rate appreciates. rises and the real exchange rate depreciates. falls and the real exchange rate appreciates. falls and the real exchange rate depreciates. In the Mundell Fleming model, if the economy is operating at or below the natural level in the short run, then in the long run the price level will fall, the exchange rate will, and net exports will to restore the economy to its natural rate. appreciate; increase appreciate; decrease depreciate; increase depreciate; decrease In the Mundell Fleming model with flexible exchange rates, an increase in the price level results in a(n) in the real exchange rate and a(n) in net exports. increase; increase increase; decrease decrease; decrease decrease; increase 17 of 27 12/8/ :42

18 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... Exhibit: IS* LM* and AD Reference: Ref 13-4 (Exhibit: IS* LM* and AD) A small open economy with a floating exchange rate is initially in equilibrium at A with Holding all else constant, if the domestic price level increases, then the curve will shift to. LM*; LM*; IS*; IS*; Exhibit: IS* LM* and AD Reference: Ref 13-4 (Exhibit: IS* LM* and AD) A small open economy with a floating exchange rate is initially in equilibrium at A with Holding all else constant, if the domestic price level decreases, then the curve will shift to. LM*; LM*; IS*; IS*; In a large open economy with a floating exchange rate, such as in the United States, in the short run a monetary contraction: 18 of 27 12/8/ :42

19 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... raises the interest rate, lowers investment and income, but does not affect the exchange rate. raises the exchange rate, lowers net exports and income, but does not affect the interest rate. initially raises the exchange rate, causing arbitrageurs to sell dollars and return the money supply to its initial level. raises the interest rate and lowers investment and income, but also raises the exchange rate and lowers net exports. In a short-run model of a large open economy with a floating exchange rate, net capital outflow as the domestic interest rate increases and is just equal to. decreases; the increase in net exports. decreases; the decrease in net exports. increases; the increase in net exports. increases; the decrease in net exports. In a short-run model of a large open economy, after net capital outflow is substituted for net exports in the IS curve: the larger the absolute value of the responsiveness of net capital outflow with respect to the interest rate, the flatter the IS curve. the larger the absolute value of the responsiveness of net capital outflow with respect to the interest rate, the steeper the IS curve. if both domestic investment and net capital outflow are very responsive to the interest rate, they will tend to cancel each other out. the slope of the IS curve depends only on the interest responsiveness of investment and the marginal propensity to consume. In a short-run model of a large open economy with a floating exchange rate: net exports determine the exchange rate, which in turn determines net capital outflow. net exports determine net capital outflow, which determines the interest rate. the interest rate is determined in the IS LM framework, and this value determines net capital outflow; then the exchange rate adjusts to make net exports equal net capital outflow. the interest rate determines investment and net capital outflow, which are equal within the IS LM framework; the exchange rate then determines net exports. In a short-run model of a large open economy with a floating exchange rate, a fiscal expansion causes an increase in: the exchange rate and a fall in net exports but has no effect on income. the money supply and an increase in income but has no effect on the exchange rate. income, the interest rate, and net exports, but a decrease in investment and in the exchange rate. income, the interest rate, and the exchange rate, but a decrease in investment and net exports. In a short-run model of a large open economy with a floating exchange rate, a monetary expansion causes a decrease in the interest rate and: the exchange rate but has no effect on income. the exchange rate, and increases in income, net capital outflow, and net exports. the exchange rate and net capital outflow, and increases in income and net exports. net exports and net capital outflow, but increases in investment and income. 19 of 27 12/8/ :42

20 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according to the Mundell Fleming model with floating exchange rates, lead to: a fall in consumption and income. no change in consumption or income. no change in income but a rise in net exports. no change in income or net exports. A fall in consumer confidence about the future, which induces consumers to spend less and save more, will, according to the Mundell Fleming model, with fixed exchange rates, lead to: a fall in consumption and income. no change in consumption or income. no change in income but a rise in net exports. a fall in income but a rise in net exports. The introduction of a stylish new line of Toyotas, which makes some consumers prefer foreign cars over domestic cars, will, according to the Mundell Fleming model with floating exchange rates, lead to: a fall in income and net exports. no change in income or net exports. a fall in income but no change in net exports. no change in income but a fall in net exports. The introduction of a stylish new line of Toyotas, which makes some consumers prefer foreign cars over domestic cars, will, according to the Mundell Fleming model with fixed exchange rates, lead to: a fall in income and net exports. no change in income or net exports. a fall in income but no change in net exports. no change in income but a fall in net exports. The introduction of automatic teller machines, which reduces the demand for money, will, according to the Mundell Fleming model with floating exchange rates, lead to: no change in income and net exports. no change in income but a rise in net exports. a rise in income but no change in net exports. a rise in both income and net exports. The introduction of automatic teller machines, which reduces the demand for money, will, according to the Mundell Fleming model with fixed exchange rates, lead to: a rise in income and net exports. no change in income or net exports. no change in income but a rise in net exports. a rise in income but no change in net exports. 20 of 27 12/8/ :42

21 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In the Mundell Fleming model with a floating exchange rate, a rise in the world interest rate will lead income: and net exports both to fall. to rise and net exports to fall. to fall and net exports to rise. and net exports both to rise. In the Mundell Fleming model with a fixed exchange rate, a rise in the world interest rate will lead income: and net exports both to fall. to fall while net exports are unchanged. to be unchanged and net exports to fall. and net exports to both be unchanged. The goods produced in U.S. industries may be made more competitive in world markets by: appreciating the U.S. currency. depreciating the U.S. currency. keeping the exchange rate fixed. expanding the money supply. If investors in a large open economy become more willing to substitute foreign and domestic assets, then this will make the net capital outflow function: steeper, and the slope of the IS curve steeper. steeper, and the slope of the IS curve flatter. flatter, and the slope of the IS curve steeper. flatter, and the slope of the IS curve flatter. Assume that the LM curve for a small open economy with a floating exchange rate is given by Y = 200r (M/P), while the IS curve is Y = G 2T + 3NX 200r. The function for NX is NX = e, where e is the * exchange rate. The price level (P) is fixed at 1.0. The international interest rate is r = 2.5 percent. a. Using the LM curve, find the equilibrium level of Y in the small open economy, if M = 100. Given this value of Y, if G = 100 and T = 100, what must be the equilibrium value of NX? c. If this value of NX is to be achieved, what must be the equilibrium exchange rate, e? a. Equilibrium Y = 500. Equilibrium NX = c. Equilibrium e = 1/3. Assume that the LM curve for a small open economy with a fixed exchange rate is given by Y = 200r (M/P). This IS curve is given by Y = G 2T + 3NX 200r. The function for the net exports is NX = e, where * e is the exchange rate. The price level is fixed at 1.0, the world interest rate is r = 2.0 percent, and the exchange rate is initially 1.0. a. If M = 100, G = 100, and T = 100, solve for the equilibrium short-run values of Y and NX. Is the initially given exchange rate equal to the equilibrium exchange rate? 21 of 27 12/8/ :42

22 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... If the Fed buys bonds in order to raise the money supply, will equilibrium Y increase? a. Equilibrium values are Y = 400 and NX = 100. The initially given exchange rate is equal to the equilibrium exchange rate. Equilibrium Y will not increase. Assume that a large open economy with a floating exchange rate is described in the short run by the equations: C = 0.5(Y T) T = 1,000 I = 1, r G = 1,500 NX = 1, e C + I + G + NX = Y M/P = 0.5Y 500r M = 1,000 CF = r NX = CF The last two equations specify that CF, net capital outflow, decreases with r, the interest rate, and that NX, the net exports, is equal to net capital outflow. NX is also related to the exchange rate, e, and falls when e appreciates. The price level (P) is fixed at 1.0. Calculate short-run equilibrium values of Y, r, C, I, CF, NX, e, private saving, public saving, and foreign saving. Foreign saving is defined here as minus NX. Check your work by ensuring that C + I + G = Y and private saving plus public saving plus foreign saving equals domestic investment. (Hint: As in the appendix to textbook Chapter 13, form the IS curve from C + I + G + NX = Y, and then substitute CF for NX to get C + I + G + CF = Y. Combine with the LM curve and solve for Y, r, and CF and then use NX = CF to get NX and the equation relating NX to e to get e.) Y = 4,000; r = 2 percent; C = 1,500; I = 1,000; CF = 0; NX = 0; e = 4; Sp = 1,500; Sg = 50; Sf = 0; 1,500 + p g 1, , = 4,000; 1, = 1,000. Here S refers to private saving, S refers to f government or public saving (T G), and S refers to foreign saving ( NX). Suppose Congress cuts government spending in order to balance the budget. Use the Mundell Fleming model with floating exchange rates to illustrate graphically the short-run impact of the cuts in government spending on the dollar exchange rate and output in the United States. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium. Suppose the government of a small open economy with a floating exchange rate imposes 50 percent tariffs on all imports. Use the Mundell Fleming model to illustrate graphically the short-run impact of the tariffs of the exchange rate and output in the country. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium. 22 of 27 12/8/ :42

23 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... In early 1994, Mexico was adhering to a fixed-exchange-rate system. Use the Mundell Fleming model to illustrate graphically the short-run impact on the exchange rate and level of output of increased country risk caused by the Chiapas uprising and the assassination of presidential candidate Colosio. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium. The increase in the risk premium shifts rate to and to To maintain the fixed exchange must shift to a. You are the chief economic adviser in a small open economy with a floating-exchange-rate system. Your boss, the president of the country, wishes to increase the level of output in the short run in order to win reelection. Do you recommend using expansionary or contractionary monetary or fiscal policy? Use the Mundell Fleming model to illustrate graphically your proposed policy. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium. a. expansionary monetary policy 23 of 27 12/8/ :42

24 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... Economic expansion throughout the rest of the world raises the world interest rate. Use the Mundell Fleming model to illustrate graphically the impact of an increase in the world interest rate on the exchange rate and level of output in a small open economy with a floating-exchange-rate system. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short-run equilibrium. Two small open economies, Fixed and Flex, can be described by the Mundell Fleming model. The countries are otherwise identical except that Fixed maintains a fixed exchange rate, while Flex maintains a flexible exchange-rate regime. The governments of both countries increase spending by the same amount. Compare what happens in the two countries to: a. the exchange rate equilibrium output c. net exports. a. The central bank in Fixed will keep the exchange rate fixed, while the exchange rate will increase in Flex. Output will increase in Fixed but will be unchanged in Flex. c. Net exports will be unchanged in Fixed (because the exchange rate does not change) but will decrease in Flex (because the exchange rate increased). Macroland is a small open economy with perfect capital mobility and a flexible-exchange-rate system. Macroland is initially in equilibrium at the natural level of output with balanced trade. Compare the impact of a tax cut in the short run (when prices are fixed) and in the long run (when prices are flexible) on: (a) output, b) consumption, (c) investment, (d) net exports, and (e) the exchange rate. a. In both the short run and long run, output is unchanged. Consumption is higher in both the short run and the long run because the tax cut increases disposable income. c. Investment is unchanged in the short run and the long run because there is no change in the world interest rate. d. In the short run and long run, net exports decrease by the amount that consumption increases because the exchange rate increases. Starting from balanced trade, the country will have a trade deficit in the short run and the long run. e. In the short run and long run, the exchange rate is higher because the tax cut puts upward pressure on the domestic interest rate, which attracts capital inflows and drives up the exchange rate. The government of a small open economy with perfect capital mobility wants to establish a stronger currency by moving its exchange rate higher. Suggest both an appropriate monetary policy adjustment and an appropriate fiscal policy adjustment that would allow the economy to move to a higher exchange rate. What are the consequences of these adjustments on domestic output and net exports? 24 of 27 12/8/ :42

25 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... Contractionary monetary policy would move the economy to a higher exchange rate. Domestic output would be reduced by the decrease in the money supply, and the higher exchange rate would reduce net exports. Expansionary fiscal policy would also move the economy to the higher exchange rate. The level of domestic output would not change, but the composition of output would change. The higher exchange rate resulting from either more government spending or more consumption spending caused by lower taxes would crowd out net exports. A U.S. Congressman wants to reduce the U.S. trade deficit by imposing tariffs on imports. Use a model of a large open economy with a flexible exchange rate to predict the impact of tariffs on U.S. imports, exports, net exports, the exchange rate, and the interest rate. The tariffs reduce the demand for imports, raise the demand for net exports, and cause the exchange rate to appreciate. The higher exchange rate reduces exports by an amount equal to the decrease in imports, so there is no change in net exports or in the trade deficit. Since there is no change in saving or investment, there is no change in the interest rate. Explain how net capital outflows change in a large open economy when there is a: a. monetary contraction fiscal contraction. a. A monetary contraction increases the domestic interest rate, which will make domestic investment opportunities more attractive and reduce net capital outflows. A fiscal contraction decreases the domestic interest rate, which will make domestic investment opportunities less attractive and increase net capital outflows. Holding everything else constant, compare the impact of a monetary expansion in a small open economy with a floating exchange rate and in a large open economy with a floating exchange rate on: a. domestic investment domestic output a. Since the world interest rate does not change, domestic investment will not change in the small open economy, but the domestic interest rate will decrease in the large open economy, which will increase domestic investment. The monetary expansion increases domestic output in both economies, but through different pathways. In the small open economy the monetary expansion will reduce the exchange rate, increasing domestic output via an increase in net exports (and induced consumption spending through the increase in income). In the large open, economy, output increases not only because of the increase in net exports, but the monetary expansion also reduces the domestic interest rate and increases domestic investment. During periods of economic downturn, there is frequently pressure to protect domestic production from foreign competition in the belief that protectionist policies will save domestic jobs. Will protectionist policies increase or decrease domestic production in a large open economy with a floating exchange rate, holding all else constant? Illustrate your answer graphically and explain in words. 25 of 27 12/8/ :42

26 26 of 27 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... The protectionist policies will not change domestic output. There is no change in net capital outflows, so the IS does not shift in the IS LM model. The protectionist polices shift the NX schedule and result in a higher exchange rate. The reduction in imports generated by the protectionist policies is met with an equal reduction in exports as a result of the higher exchange rate, resulting in no change in net exports or in domestic output. What type of monetary or fiscal policy will generate both a stronger economy (increased Y) and a stronger dollar (increased e) in a large open economy with a floating exchange rate? Explain. Expansionary fiscal policy raises domestic output and domestic interest rates. The higher domestic interest rates will reduce net capital outflows and increase the exchange rate, thereby generating both stronger output and a stronger exchange rate. Graphically illustrate and explain how a steep decline in the value of the stock market and housing prices would affect the level of domestic output, the interest rate, and the exchange rate in a large open economy with a floating exchange rate. The stock market and housing price declines reduce consumption spending and shift the IS curve to the left, resulting in lower output and a lower domestic interest rate. The lower interest rate makes domestic investment opportunities less attractive and increases net capital outflows, which reduces the exchange rate and increases net exports. Thus, output, the interest rate, and the exchange rate all decline as a result of the stock market and housing price declines. 12/8/ :42

27 file:///c:/users/moha/desktop/mac8e/new folder (13)/CourseComp... The impossible trinity refers to the idea that a country can simultaneously pursue only two of the three following policies: free international-capital flows, monetary policy for domestic stabilization, and a fixed exchange rate. For each of the following combinations indicate what the economy gives up by selecting the combination and why the omitted policy cannot be achieved: a. a fixed exchange rate and free international-capital flows a monetary policy for domestic stabilization and a fixed exchange rate c. a monetary policy for domestic stabilization and free international-capital flows a. The economy loses the ability to use monetary policy for domestic stabilization because monetary policy must be used to maintain the fixed exchange rate. The economy must restrict the free flow of international capital to isolate the determinants of the domestic interest rate from the world interest rate, so monetary policy can be used to influence the domestic economy and at the same time fix the exchange rate. c. The economy cannot fix the exchange rate because monetary policy is used for domestic stabilization rather than to fix the exchange rate. The free flow of capital ensures that the domestic interest rate is determined by the world interest rate rather than by domestic monetary policy. 27 of 27 12/8/ :42