Workbook for Open Economy ISLM ECON 301 I. Fiscal Policy with Fixed Exchange Rates Consider a tax cut. 1. As taxes are cut, what will happen to exports X? 2. What will happen to equilibrium output Y? As a consequence, what will happen to imports? 3. What will happen to net exports NX? 4. Draw the effect of lower T on Y and NX. Z Y=Z Z Y NX Y NX 5. Since we are assuming a fixed nominal exchange rate (and constant prices), what will happen to ε ? 6. If there is a tax cut and exchange rates are fixed, what happens in the IS-LM-foreign exchange diagram? Draw the effect of this on the graph be-low.Draw the interest parity line here. IS’ (Hint: to keep the exchange rate constant, what will the CB have to do to interest rates? How will the CB accomplish that goal?) Assume that the economy is described by the following model: C = c0 + c1(Y–T) I = b0– b1i G = G IM = im1Y -im2ε X = x1Y*+x2ε NX = X - εIM P*=P=1 Ee =1 Assume that the Marshall-Lerner condition is satisfied and that the interest rate parity condition holds. The LM equation in this economy is i = (1/m2)(m1Y – Ms/P) 7. Write down the interest parity condition. 8. If E=Ee=1, what does the interest parity condition become? 9. If you plug in your answer into the LM equation, you will find that i is no longer determined by the LM equation and that MS is no longer free to af-fect output. Do we still need the LM equation? 10. Using the equations above, derive the IS equation for this economy. 11. Using calculus, calculate the effect of the change in taxes T on domestic output Y. =TY∆∆ i i E Y ISLM12. Assume that (c1 – ɛ im2) < 1. Is TY∆∆ positive or negative? 13. Combining the equations for exports (X = x1Y**+x2ε) and imports (IM = im1Y-im2ε) into the equation for net exports (NX = X - εIM), write out the equation for Net Exports as a function of output and the real ex-change rate. 14. What is the effect of a change in output on net exports if the exchange rate is constant? =YNX∆∆ 15. We don’t have an equation for how taxes affect net exports, but we have equations for how taxes affect income and for how income affects net ex-ports. We can use the chain rule of calculus to find what we are looking for. =×=911 QuestiontoansweryourQuestiontoansweryourTYYNXTNX∆∆∆∆∆∆ With what you have found, you can say that an increase in taxes of ∆T will cause net exports to rise by ∆NX = ____________ ∆T 16. What is the effect of a tax cut on net exports if the exchange rate is con-stant?II. Fiscal Policy with Flexible Exchange Rates 1. If there is a tax cut and exchange rates are flexible, what happens in the IS-LM-foreign exchange diagram? Draw the interest parity line here. IS’ 2. What happens to output? 3. What happens to the domestic interest rate (i)? 4. What happens to the nominal exchange rate (E)? 5. What happens to the real exchange rate (ε), assuming prices are fixed? 6. Given your answers, what happened to exports X? to imports? 7. What happens to net exports? III. Fiscal Policy in Comparison 8. Looking at the ISLM diagrams you drew for both cases (fixed and flexible exchange rates), which one had a greater increase in output? 9. Which one had the greatest change in investment, in what direction, and why? 10. Which one had the greatest change in net exports, in what direction, and why? i i E Y ISLMIV. Monetary Policy in a Closed Economy Consider a monetary expansion. 1. If the CB wants to expand MS and exchange rates are fixed, what happens in the IS-LM diagram? 2. What will happen to equilibrium output Y? Assume that the economy is described by the following model: C = c0 + c1(Y–T) I = b0 + b1Y – b1i G = G 3. Using the equations above, derive the IS equation for this economy. i Y ISLMV. Monetary Policy in an Open Economy Assume that the economy is described by the following model: C = c0 + c1(Y – T) I = b0 + b1Y – b1i G = G NX = nx1Y* - nx2Y + nx3ε P*=P=1 Ee =1 1. Starting from the interest parity condition, we can define the exchange rate as ()*1 iiEEe−+=. Do the algebra to show this. 2. Using the equations above, and combining them with the re-written inter-est-parity condition of question 1, derive the IS equation for this economy. 3. Looking at your IS curve, you should find that higher interest rates lower output through two channels. What are the two channels? 4. From this, is the open-economy IS curve flatter or steeper than the closed-economy IS curve? (Hint: higher interest rates are vertical movement in the ISLM diagram, the “rise” of the slope). 5. If there is a monetary expansion, what happens in the IS-LM-foreign ex-change diagram? Draw the slope of the IS curve according to what you found above. Draw the interest parity line here. 6. What happens to output? i i E Y ISLM7. What happens to the domestic interest rate (i)? 8. What happens to the nominal exchange rate (E)? 9. What happens to the real exchange rate (ε), assuming prices are fixed? 10. What happens to net exports (given what you found about Y and ε)? 11. Draw the effect of the change of interest rates and of the exchange rate on Y and NX. Z Y=Z Z Y NX Y NX (Hint: depending on how you draw the shifts, you could find that the results is a trade deficit or a trade surplus) VI. Monetary Policy in Comparison 1. Looking at the ISLM diagrams you drew for both cases, which one had a greater increase in output after the monetary