CHAPTER12The Open Economy RevisitedQuestions For Review1

Topics: Monetary policy, Inflation, Foreign exchange market Pages: 25 (5327 words) Published: November 16, 2014
CHAPTER

12

The Open Economy Revisited

Questions for Review
1. In the Mundell–Fleming model, an increase in taxes shifts the IS* curve to the left. If the exchange rate floats freely, then the LM* curve is unaffected. As shown in Figure 12–1, the exchange rate falls while aggregate income remains unchanged. The fall in the exchange rate causes the trade balance to increase.

e

LM*

Exchange rate

Figure 12–1

A

B
IS2*

IS1*
Y

Income, output

119

Answers to Textbook Questions and Problems

Now suppose there are fixed exchange rates. When the IS* curve shifts to the left in Figure 12–2, the money supply has to fall to keep the exchange rate constant, shifting the LM* curve from LM*1 to LM*2. As shown in the figure, output falls while the exchange rate remains fixed.

Net exports can only change if the exchange rate changes or the net exports schedule shifts. Neither occurs here, so net exports do not change.

Exchange rate

e

LM*2

B

e

Figure 12–2

LM*1

A

Fixed
exchange
rate
IS1*

IS2*
Y2

Y

Y1
Income, output

We conclude that in an open economy, fiscal policy is effective at influencing output under fixed exchange rates but ineffective under floating exchange rates. 2. In the Mundell–Fleming model with floating exchange rates, a reduction in the money supply reduces real balances M/P, causing the LM* curve to shift to the left. As shown in Figure 12–3, this leads to a new equilibrium with lower income and a higher exchange rate. The increase in the exchange rate reduces the trade balance.

e

Exchange rate

120

*

LM2

Figure 12–3

*

LM1

B

A
IS*
Y2
Income, output

Y1

Y

Aggregate Demand in the Open Economy

Chapter 12

121

If exchange rates are fixed, then the upward pressure on the exchange rate forces the Fed to sell dollars and buy foreign exchange. This increases the money supply M and shifts the LM* curve back to the right until it reaches LM*1 again, as shown in Figure 12–4.

Exchange rate

e

e

*

LM1

Fixed
exchange
rate

Figure 12–4

A

IS*
Y
Income, output

In equilibrium, income, the exchange rate, and the trade balance are unchanged. We conclude that in an open economy, monetary policy is effective at influencing output under floating exchange rates but impossible under fixed exchange rates. 3. In the Mundell–Fleming model under floating exchange rates, removing a quota on imported cars shifts the net exports schedule inward, as shown in Figure 12–5. As in the figure, for any given exchange rate, such as e, net exports fall. This is because it now becomes possible for Americans to buy more Toyotas, Volkswagens, and other foreign cars than they could when there was a quota.

Exchange rate

e

Figure 12–5

e

NX1(e)
NX2(e)
NX2

NX1

Net exports

NX

Answers to Textbook Questions and Problems

This inward shift in the net-exports schedule causes the IS* schedule to shift inward as well, as shown in Figure 12–6.
e

LM *

Exchange rate

Figure 12–6

e1

A

e2

B
IS1*
IS2*
Y
Income, output

Y

The exchange rate falls while income remains unchanged. The trade balance is also unchanged. We know this since
NX (e) = Y – C(Y – T) – I(r) – G.
Removing the quota has no effect on Y, C, I, or G, so it also has no effect on the trade balance. The decline in net exports caused by the removal of the quota is exactly offset by the increase in net exports caused by the decline in the value of the exchange rate. If there are fixed exchange rates, then the shift in the IS* curve puts downward pressure on the exchange rate, as above. In order to keep the exchange rate fixed, the Fed is forced to buy dollars and sell foreign exchange. This shifts the LM* curve to the left, as shown in Figure 12–7.

Exchange rate

122

e

LM2*

LM1*

e

B

A

Figure 12–7

e
*
IS1
*

IS2

Y2

Y1

Y

Income, output

In equilibrium,...
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