Discuss the following statement: Flexible exchange rates do suck because they lead to too much instability. Plus, fiscal policy is useless unless the exchange rate is fixed. Document Preview: Problem...

PROBLEM SET 3
Q1
a) C = 10 + 0.9Y
------------------ (1)
This consumption function implies that autonomous consumption is worth $10, while the MPC is 0.9, so that 90% of any increase in income will be devoted to consumption. The plus (+) sign indicates a positive relationship between total consumption (C) and income (Y). As income increases, total consumption also increases.
I = 10 – 100 r
------------------ (2)
This investment function implies that autonomous investment is worth $10, and there is a negative relationship between total investment (I) and rate of interest (r), as indicated by the negative (–) sign. A rise in domestic rate of interest leads to a fall in total investment.
CA = 2E – 0.15Y
------------------ (3)
This equation indicates that current account balance (CA) is directly related to the exchange rate (E) and negatively related to income. As the exchange rate depreciates (increase in domestic currency per unit foreign currency) the current account balance improves. On the other hand when income increa = ses the CA deteriorates due to an increase in imports.
FA = 1356 r
------------------ (4)
This equation indicates that financial account balance (FA) is directly related to the rate of interest (r). As the domestic interest rate increases the financial account balance improves due to capital inflows.
Md = 2Y – 200 r
------------------ (5)
This is the equation for money demand in which 2Y is the transactions demand for money and it is positively related to income. The -200r is the speculative demand for money and it is negatively related to domestic interest rate r.
Yes, it is a small country.
b) Equation for IS curve is given by equilibrium in the goods market, so that:
Y = AD; where
AD = C + I + G
Given G = 100
Therefore AD = 10 + 0.9Y + 10 – 100 + 100
Equating it to Y gives
Y = 10 + 0.9Y + 10 – 100 + 100
Solving for Y in terms of r yields the equation for the IS curve:
Y = 1200 – 1000 r
------------------ (6)
The negative sign of the r term indicates that the IS curve is downward sloping. A fall in r increases investment and thus increases Y.
Similarly, equation for LM curve is given by equilibrium in the money market, so that:
Md = Ms
Ms = 934 (given)
Therefore :
934 = 2Y – 200 r
Solving for Y in terms of r yields the equation for the LM curve:
Y = 467 + 100r
------------------ (7)
The positive sign of the r term...