Chapter 6

P1. Use the model of the small open economy to predict what would happen to the trade
balance, the real exchange rate, and the nominal exchange rate in response to each of the
following events.
a) A fall in consumer confidence about the future induces consumers to spend less and
save more.
As saving increases, the supply of funds will also increase (domestic investment does not
increase because consumption falls). The excess funds flow abroad causing investment in
abroad increases, hence nominal exchange rate decreases (depreciates). Depreciation of
nominal exchange rate causes
b) A tax reform increases the incentive for businesses to build new factories. (fall in tax)
Domestic investment will increase, hence fund available for investment abroad decreases.
As a result, real exchange rate increases (value of the currency appreciates). At higher
real exchange rate, export falls and import increases. Therefore, net export falls
(deteriorates). Nominal exchange rate

c) The central bank doubles the money supply.

P9. Oceania is a small open economy. Suppose that a large number of foreign countries
begin to subsidize investment by instituting an investment tax credit (while adjusting other
taxes to hold their tax revenue constant), but Oceania does not institute such an investment
subsidy.
a) What happens to world investment demand as a function of the world interest rate?
World investment demand is a function of world interest rate (r*). Increases in
investment demand in foreign economies will shift investment demand from I1 to I2.

b) What happens to the world interest rate?

To see the effect of investment demand on interest rate, the supply of fund has to be
added to the diagram to find the equilibrium

c) What happens to investment in Oceania?

Increases in world interest rate (r*) causes the required rate of return on investment in
Oceania to increase. As a result, investment in Oceania decreases.

d) What happens to Oceania’s trade balance?

Since domestic interest rate has not changed, higher foreign interest rate leads to
improvement in trade balance in the domestic economy (Oceania).

*If domestic interest rate is low, the exchange rate (value of the currency) tends to be
low. If this happens, it will be attractive for the export sector.

e) What happens to Oceania’s real exchange rate?

 Increases in the foreign interest rate cause decreases in the domestic investment. (S-I)
curve shifts to the right from (S-I)1 to (S-I)2. The supply of funds available for investment
to abroad increases. Domestic currency’s value fall (depreciates). Hence, imports fall
while exports increase.

Chapter 7
Q2. Describe the difference between frictional unemployment and structural
unemployment.

P6. Suppose that a country experiences a reduction in productivity – that is, an adverse
shock to the production function.
a) What happens to the labor demand curve?
Labor demand falls as productivity falls.

b) How would this change in productivity affect the labor market—that is,
employment, unemployment, and real wages—if the labor market is always in
equilibrium?
Real wage falls but it has no effect on employment.

c) How would this change in productivity affect the labor market if unions prevent
real wages from falling?
If wage is not allowed to fall (wage rigidity), there will be unemployment. If real wage
remained at (W/P)1, labour demand is at L1 while labour supply is at L*. Hence, there is
unemployment indicated by the gap between L1 and L*.