5. Suppose that money demand depends on disposable income, so that the equation

Question

5. Suppose that money demand depends on disposable income, so that the equation for the money

market becomes M/ P = L( r, Y - T). Analyze the short- run impact of a tax cut in a small open

economy on the exchange rate and income under both floating and fixed exchange rates.

6. Suppose that the price level relevant for money demand includes the price of imported goods and that

the price of imported goods depends on the exchange rate. That is, the money market is described by

M/ P = L( r, Y), where P =? Pd + ( 1 -? ) Pf/ e. Here, Pd is the price of domestic goods, Pf is the price

of foreign goods measured in the foreign currency, and e is the exchange rate. Thus, Pf/ e is the price

of foreign goods measured in the domestic currency. The parameter ? is the share of domestic goods

in the price index P. Assume that the price of domestic goods Pd and the price of foreign goods

measured in foreign currency Pf are sticky in the short run.

a. Suppose that we graph the LM * curve for given values of Pd and Pf ( instead of the usual P).

Is this LM * curve still vertical? Explain.

b. What is the effect of expansionary fiscal policy under floating exchange rates in this model?

Explain. Contrast with the standard Mundell

Explanation / Answer

5

he tax-cut multiplier is MPC/1-MPC, it will increase income so that Y-T will increase. If r is constant, M/P will increase. An increase in money supply will depreciate the exchange rate by given interest rate.

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