Assume that the LM curve for a small open economy with a floating exchange rate
ID: 1214492 • 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 = 100.
b.
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?
Have all answers so please just show steps
a.
Using the LM curve, find the equilibrium level of Y in the small open economy, if M = 100.
b.
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?
Explanation / Answer
A)
Simplify to:
M=100 (money supply)
P=1.0 (price level)
Y = 200r - 200 + 2(M/P) = 200r-200+200 = 200r
[LM] Y=200r
r = r* = 2.5
Y = 200 * 2.5 = 500
[LM*] Y=200*2.5 = 500 (Mundell-Flemming LM* curve)
LM* is independent from exchange rate in this case, thus is vertical line fixed at Y=500 for Mundell-Flemming model
G=100
T=100
Y=400+3G-2T + 3NX - 200r
NX = 200-100e
[IS] Y = 400 + 300 - 200 + 600 - 300e - 200r
r = r* = 2.5
Y = 600 - 300e
[IS*] Y=600 - 300e (Mundell-Flemming IS* curve)
Equilibrium:
Y = 600 - 300e ; [IS*]
Y=500 ; [LM*]
500 = 600 - 300e
e = 1/3
Fiscal policy is ineffective with such fixed monetary policy [LM*] and fixed price level, so fiscal policy will cause only changes in exchange rate (thus trade balance, CA , BoP, CF).
B)
NX = 200 - 100/3 = 500/3 = 166.67
C)
e=1/3