Flexible exchange rates and foreign macroeconomic policy. Consider an open econo
ID: 1205536 • Letter: F
Question
Flexible exchange rates and foreign macroeconomic policy. Consider an open economy with flexible exchange rates. Let UIP stand for the uncovered interest parity condition. In an IS - LM- UIP diagram, show the effect of an increase in foreign output, Y^*, on domestic output, Y. Explain in words. In an IS - LM - UIP diagram, show the effect of an increase in the foreign interest rate, i^*, on domestic output, Y. Explain in words. Given the discussion of the effects of fiscal policy in this chapter, what effect is a foreign fiscal expansion likely to have on foreign output, Y*, and on the foreign interest rate, i*? Given the discussion of the effects of monetary policy in this chapter, what effect is a foreign monetary expansion likely to have on Y* and i*? Given your answers to parts (a), (b), and (c), how does a foreign fiscal expansion affect domestic output? How does a foreign monetary expansion affect domestic output?Explanation / Answer
a. The IS curve shifts right, because net exports tend to increase. Domestic output increases.
b. The IS curve shifts right, because the increase in i* tends to create a depreciation of the domestic currency and therefore an increase in net exports. Domestic output increases. The interest parity line also shifts up.
c. A foreign fiscal expansion is likely to increase Y* and to increase i*.
A foreign monetary expansion is likely to increase Y* and to reduce i*
d. A foreign fiscal expansion is likely to increase home output.
A foreign monetary expansion has an ambiguous effect on home output. The increase in Y* tends to increase home output, but the fall in i* tends to reduce home output.
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