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Question

Please help these problems with explanation trying to learn, Thanks

Consider the following small open economy: where C denotes consumption, Y denotes output, I denotes investment, r denotes the real interest rate in percentage, P denotes the price level, e denotes the nominal exchange rate, T denotes the lump-sum tax, G denotes the government spending, and M denotes the money supply. The nominal exchange rate is defined as how much foreign currency can be obtained when one unit of the domestic currency is sold, as in class or in our textbook. The world real interest rate is determined in the global loanable fund market and 3%. Prices are fixed at 10 in the short run. Also, assume that there are idle resources for the production. Find the current short-run equilibrium output, nominal exchange rate, and net export for this small open economy. The exchange rate is determined freely in the currency market. Suppose that the central bank has announced the nominal exchange rate system is fixed at the level in (a). Also, suppose that after the announcement of the central bank, all other countries in the world have raised their government expenditure, which results in the rise of the world interest rate to 6%. Find the new short-run equilibrium output, and the new money supply for this small open economy. Draw an IS*-LM* diagram in the space of (Y, e) to show the effect of the increase in the world interest rate. Suppose that the central bank continues to fix the nominal exchange rate at the level in (a). Also, suppose that the government reduces imports by imposing an unport quota. As a result, the net export function becomes NX = 4 - e. The world interest rate is 6%. Find the new short-run equilibrium output, and the new money supply for this small open economy. Draw an IS*-LM* diagram in the space of (Y, e) to show the effect of the change in the net export function.

Explanation / Answer

Equilibrium in fund market is where the real demand is equal to real supply of money

300/10 = 3Y-2r

r=3

30 =3Y-2x3

36=3Y

Y=12

National income is 12.

We also knwo aggregate expenditure is equall to income, Y:

Y = C+I+G+NX

Y = 2+3/5(12-2)+ (4-1) +2+3-e

12 = 16-e

e = 4

(b) With r = 6 and e = 4

NX = 3-4 = -1

Y = 2+3/5(Y-2)+ (4-2) +2-1

Y = 5 + 0.6Y-1.2

0.4Y = 3.8

Y = 9.5

Money demand is equal to money suplly:

3Y-2r

3x9.5 - 2x6 = 16.5

With increase in interest rate, money supply falls.

(c) With r=3 and Nx=4-e=4-4 = 0

Y = 2+3/5(Y-2)+ (4-1) +2+0

Y = 7 + 0.6Y-1.2

0.4Y = 5.8

Y=14.5

With decrease in interest rate income increases

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