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SCHOOL OF ECONOMICS

Economics 101

Exercise Set 5

1. Assume that in a small open economy where full employment always prevails, national saving is

300.

a. If domestic investment is given by I= 400 – 2r, where r is the real interest rate in percent,

what would the equilibrium interest rate be if the country were closed?

b. If the economy is open and the world interest rate is 10 percent, what will investment be?

c. What will the current account surplus of deficit be? What will net foreign investment be?

2. Assume that in a small open economy with full employment, consumption depends only on

disposable income. National saving is 300, investment is given by I = 400 – 20r, where r is the

real interest rate in percent, and the world interest rate is 10 percent.

a. If government spending rises by 100, does investment change? What is the level of

investment after the change?

b. Does the trade balance change if G rises by 100? If it changes, does it increase or decrease,

and by how much?

c. Does net foreign investment change if G rises by 100? If it changes, does it increase or

decrease? And by how much?

d. Will the real exchange rate rise, fall, or remain constant as a result of the change in G?

3.

a. If corporate downsizing and lack of job security cause consumers to spend less and save

more, what will be the impact on the exchange rate and trade balance? Use the long-run

model of a small open economy to illustrate graphically the impact of this decline in

consumer confidence on the exchange rate and the export rate and the trade balance. Assume

the country starts from a position of trade balance, i.e., exports equals imports. Be sure to

label: (i) the axes; (ii) The curves; (iii) The initial equilibrium values; (iv). The direction the

curves shift; and (v) the new long-run equilibrium values.

b. Based on your graphical analysis, explain the predicted impact of a decline in consumer

confidence on the exchange rate and the U.S. trade balance.

4. Suppose that the International Monetary Fund (IMF) is concerned about currency depreciation in

a small open economy.

a. What type of fiscal policy should the IMF propose to government of the small open

economy to generate a currency appreciation?

b. Illustrate graphically the impact of the IMF proposal on the exchange rate of the small

open economy.

c. What will happen to the trade balance of the small open economy, assuming that it started

from a position of balanced trade?

5. The government of a small open economy wishes to promote trade policies that will result in

currency appreciation.

a. Would protectionist policies (higher tariffs and more quotas) or freer trade policies (tariff

reductions and quota eliminations) be more effective in generating currency appreciation?

b. Illustrate graphically the impact of the trade policy on the exchange rate of the small open

economy.

c. What will happen to the trade balance of the small open economy as a result of the trade

policies, assuming that the country started from a position of free trade?

d. What will happen to the quantity of exports and imports as a result of the trade policies?

6. 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?

7. Assume that the LM curve for a small open economy with a fixed exchange rate is given by Y=

200r – 200+ 2(M/P). This IS curve is given by Y=400 + 3G – 2T + 3NX – 200r. The function for the net

exports is NX = 200 – 100e, where e, is the exchange rate, and the exchange rate is initially 1.0.

a. If M=100, G=100, and T=100, solve for the equilibrium short-run values of Y and NX. Is

the initially given exchange rate equal to the equilibrium exchange rate?

b. If the BSP buys bonds in order to raise the money supply, will equilibrium Y increase?

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