Assume that the LM Curve for a small open economy with a floating exchange rate
ID: 1214469 • Letter: A
Question
Assume that the LM Curve for a small open economy with a floating exchange rate is given by Y=200r-200+2(M/P),while the IS curve is Y=400+3G-2T+3NX-200r. The function for NX is NX=200-100e, 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:
b. Given this value of Y, If G=100 and T=100, what must be the equilibrium value of
c. if this value of NX is to be achieved, what must be the equilibrium exchange rate,e?
Explanation / Answer
A)
M=100
P=1.0
Y = 200r - 200 + 2(M/P) = 200r - 200+200 = 200r
Y=200r
Substituting the value of r = 2.5
Y = 200 * 2.5 = 500 (LM)
B)
G=100
T=100
Y=400 + 3G - 2T + 3NX - 200r
Substituting the value of G, T, r , and NX = 200-100e
Y = 400 + 3(100) - 2(100) + 3(200 - 100e) - 200(2.5)
= 400 + 300 - 200 + 600 - 300e - 500
Y = 600 - 300e (IS)
For Equilibrium: IS = LM
IS: Y = 600 - 300e
LM: Y=500 ; [LM*]
500 = 600 - 300e
e = 1/3
NX = 200 - 100/3 = 500/3 = 166.67
C)
e=1/3
Answ:
A) Y = 500 (It would be 550 without trade, and "r" would be 2.75)
B) NX = +166.67
C) e = 1/3