I. (6 pts.) Choose the correct answer on each case based on your knowledge of th
ID: 2440113 • Letter: I
Question
I. (6 pts.) Choose the correct answer on each case based on your knowledge of the Mundell-Fleming model: 1. (3 pts.) Assume that in a small open economy with perfect capital mobility there is an short-run under a fixed rease in the demand for money. What happens in the exogenous dec and floating nominal exchange rates to equilibrium income Y? Under floating rates Y will rise; under fixed rates Y will not change Under floating rates Y will not change; under fixed rates Y will rise Under both fixed and floating rates, Y will rise Under both fixed and floating rates, Y will not change a. b. c. d. 2. (3 pts.) Suppose that in a small open economy with perfect capital mobility the home country operates a fixed exchange rate. Moreover, everything else remaining unchanged (ceteris paribus), investments in the home country become less risky. As a consequence, the risk premium of making loans to the home country falls. For the home country, the effect of the decreasing risk premium will be that a. The foreign-currency reserves will decrease, and national income will fall. b. The foreign-currency reserves will increase, and national income will fall c. The foreign-currency reserves will decrease, and national income will remain constant. d. The foreign-currency reserves will increase, and national income will increaseExplanation / Answer
1. Under floating y will change , under fix y will not change ( Fall in money demand means savings will be more . Due to increased savings interest rate will fall this will lead to outflow of foreign capital . Due to capital outlow demand for foreign currency will increase and supply of domestic currency will increase. Central bank will provide supply foreign currency and will buy domestic currency thus reducing the money supply . This means initial fall in money demand will equal money supply and hence there will be no change in output. )
2. Foreign reserves will decrease and national income will fall.( Due to fall in risk prenium return on domestic bonds will fall and hence this will lead to capital outflow. Due to outflow demand for foreign currency increases and supply of foreign currency will increase . Central bank will intervene by selling foreign currency and buying domestic currency and hence reducing money supply and hence reserves of foreign currency and output.)