Macroeconomics I

2023-2024
Problem Set #2: Deadline Oct 24th
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Instructions: Work with your seminar group. Submit ONE answer in PDF in Aula Global (Turnitin) by the
deadline. For math questions, indicate the main steps needed to get your answer. In your graphs, clearly label the
axis, variables, and equilibriums. If you present data, do not paste all your calculations into the PDF.
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Exercise #1: The Fiscal Multiplier in an Open Economy

Consider a world with only two countries (say Spain and Germany). Assume the Spanish economy is characterized
by the following set of equations:

C = 1000 + 0.6 (Y-T)

IM = 0.4Y + 400E

X = 0.4Y* + 400/E

I = G = T = 1000

where E denotes the nominal exchange rate and Y* denotes foreign output. Assume that the nominal exchange rate
is fixed and equal to 1, i.e. E =1. All throughout, assume that 𝑃=𝑃∗ =1.

A. One country equilibrium.

A1. Explain the effect of the exchange rate on imports and exports.
Exports depend negatively on the exchange rate and impo. To understand it let’s puta n example: if one
domestic car costs 2 foreign cars, people will prefer purchase foreign cars, so exports will decrease and imports
will increase. Otherwhise, if one domestic car we costs 0.5 foreign cars, people will prefer to purchase domestic
cars,
so imports will decrease and exports will increase.

A2. What is the fiscal multiplier (dY/dG) in this economy?

A3. If we were to close the economy (no exports and no imports), what would the multiplier be? Why
would it be different? Explain.
The fiscal multiplier tells us how the change in fiscal policies (for example an increase in G) affect the GDP
(Y).
So if the government have a huge control of the economy, for example, there are a lot of restriccions in exports
or imports, the fiscal multiplier probably will be higher. Otherwise, if the country depends a lot on the
international markets, probably the fiscal multiplier will be lower.
Keeping that in mind, in a close economy the fiscal multiplier would be lower than in a open economy.

A4. For a given foreign output level Y*, solve for the domestic equilibrium output, consumption, and net
exports.
B. International equilibrium. Assume that the same equations characterize the German economy as the Spanish
economy.
B1. Use the two sets of equations to solve for the equilibrium output of each economy.

B2. Make a plot that shows the German output on the x-axis and the Spanish output on the y-axis, and
plot both countries' policies. Mark the equilibrium.

B3. What is the fiscal multiplier in each country now? Why is it different than in the multiplier in the
onecountry equilibrium? Explain.
We can compute fiscal multiplier as dY/dG, so if we increase G from 1000 to 2000 we can compute the fiscal
multiplier of both countries looking at the increase in output:

As we’ve seen in question A3, if the country depends a lot on other economies, for example, the German
economy, the fiscal multiplier will decrease because the effect in the economy of a fiscal policy by the
government will be lower.

C. Unilateral fiscal policy. Assume that the Spanish government has a target output level equal to 10,000.
C1. What is the increase in government spending G necessary to achieve the target output in Spain
(assuming the German government keeps its expenditure constant at G*=1000)?

C2. Solve for net exports and the budget deficit in each country.

C3. Are there any positive or negative externalities in Germany from the Spanish fiscal policy?
Yes, while the German budget deficit remains constant (equals 0), their output has increased from 6000 to 8000,
in part because their net exports have increased from 0 to 800.
On the other hand, the Spanish budget deficit is now -2400 and the net exports are -800 (so imports > exports).

D. Coordinated fiscal policies. Suppose that both governments have a target output of 10,000 and each increases
government spending by the same amount.
D1. What is the increase in G and G* necessary to achieve the target output in both countries?
D2. Solve for net exports and the budget deficit in each country.
D3. Is the increase in government expenditure larger or smaller than in the case of a unilateral fiscal policy?
Please explain your answer and relate it to the multipliers you found in the questions above.
The increase in the government expenditure is smaller than in the case of the unilateral fiscal policy, in that case
the required G was 3400 and in this case the G is 2600. We can relate it to the fiscal multiplier found in the
question B3 (1.25), because the increase in output for Germany is 8000-10000=2000 and the 1.25 tells us that
each increase of 1 unit in G* will increase the output 1.25 units, so 1.25*1600 (increase in G*)=2000.

E. Role of coordination. Let us now compare your answers for unilateral vs. coordinated fiscal policies.
E1. Which scenario is the most favorable for each country?
For Spain is the coordinated fiscal policy, because they increase their output from 6000 to 10000 and they only
have a budget deficit of -1600. Moreover the net exports are 0 instead of -800.
For Germany is the unilateral fiscal policy, because they get a increase of 2000 units in output having a budget
deficit of 0 and a net exports of 800.

E2. Why is fiscal coordination, such as the common increase in government spending, difficult to achieve in
practice?
 Because there are a lot of factors that can differentiate the situations on both economies, for example, the
Spanish economy can have a huge inflation and may not interest an increase in government spending, or
Germany can have less taxes (T) and the budget deficit may increase too much.
Finally, its true that a coordinated fiscal policy could be useful for both countries, but the countries will prefer
remain their government expenditures low and let the foreign country apply the expansionary fiscal policy.

E3. Discuss the potential role of international coordination.

Since It could be difficult to get an agreement between both countries, It may be useful to have an
international institution like the European Union to achieve this coordinated policies.

Exercise #2: Fiscal Policy and the Exchange Rate in the UK

Last year, the British government unveiled a new fiscal stimulus package amounting to £45 billion. The financial
market reaction was adverse: interest rates on UK government bonds increased (Figure 1) while the British Pound
depreciated against the dollar (Figure 2), reaching an all-time low since the 1950s.

Interest Rates in UK Nominal Exchange rate in UK (𝐄$/£ 1 pound buys X $’s)

Figure 1 Figure 2

a) Using the simple Mundell-Fleming model (IS-LM-UIP), what would be the short-run effects of a fiscal
expansion on output, the exchange rate, the interest rate, and the trade balance (treat the British economy as
the domestic economy, and assume that the expected exchange rate and foreign output remain constant)?
Are the predictions of this simple model consistent with what was observed in reality?

b) Compare your answer to point a) to what would happen in a closed economy in response to a fiscal
expansion. For instance, would the change in output be larger or smaller? Why?

c) According to the IMF, the main underlying reason underlying the adverse reaction of financial markets is
the doubt that the fiscal deficit is sustainable in the long term. As we have seen in class, this could be
thought of as an increase in the “default risk” in the UK.
 Considering this effect and using the IS-LM-UIP diagram, show the effects of a fiscal expansion on output,
interest rates, and the exchange rate (suppose the central bank keeps the interest rate constant, and the
expected exchange rates and foreign output are constant).

d) What could the central bank do to mitigate the exchange rate depreciation? Explain your answer, using the
IS-LM-UIP diagram.

e) Use your answers from c) and d) to interpret the data in Figure 1 and Figure 2.

Exercise #3: Quizzes on Open Economy

This is an individual activity.

In Aula Global, two multiple-choice quizzes on the Open Economy will be found.

a. Each quiz contains 10 questions that should be answered in a limited time (10 minutes).
b. You have unlimited trials, and new random questions will appear every time you enter a quiz.
c. Only the highest score will count, so try it as many times as possible until you get it all perfect. d. You
must complete them by the deadline!

Deadlines:

• Open Economy #1: October 29th, at 20.00h (from last week)

• Open Economy #2: November 5th, at 20.00h (new)