ECON 3602 - Assignment 2 with solutions - Winter 2023

International Monetary Problems (Carleton University)

Scan to open on Studocu

Studocu is not sponsored or endorsed by any college or university

Downloaded by niguse tesfaye (nigust29@gmail.com)
 Assignment 2
ECON 3602, Winter 2023

Instructions:

1. Upload the assignment on BrighSpace by the due date. Do not email

the assignments.
2. Type your answers. Handwritten assignments will not be marked. However, you
may hand draw the graphs. You may upload the electronic file (MS Word, PDF),
the scan of the assignment, or a clear picture of the assignment.
3. Assignment 1 accounts for 10% of the final grade.

Question 1. This question will compare the policies of the federal government and the Federal
Reserve and their likely effects on interest rates, exchange rates, output, and the trade balance
during the mid- to late 1970s.
a. President Lyndon Johnson and Congress passed large increases in government
spending to finance Great Society programs and the Vietnam War. Explain briefly how
such spending affects the trade balance.
Answer: A fiscal expansion leads to an increase in interest rates and an appreciation in
the currency. Also, a fiscal expansion increases home output. Both the increase in home
output and the appreciation led to a decrease in the trade balance.
b. Beginning in the mid-1970s, Federal Reserve chairman Arthur Burns sought to lower
unemployment below its full employment level by decreasing interest rates. Does this
require a monetary expansion or a contraction?
Answer: This requires a monetary expansion.
c. Illustrate the effects of the fiscal and monetary policies mentioned previously using
the IS‒LM‒FX market diagram. [Note the change in interest rates observed in (b).]
Answer: See the following diagram. Because interest rates fell in the mid-1970s, we
know that the shift in the LM curve associated with the monetary expansion must be
larger than the shift in the IS curve associated with the fiscal expansion. Point B shows
the effects of the fiscal expansion alone.

Downloaded by niguse tesfaye (nigust29@gmail.com)

 d. State the effects of these policies on the following variables: output, interest rate,
nominal exchange rate, consumption, investment, and the trade balance.
Answer: Y ↑, i ↓, E ↑, C ↑, I ↑, TB ↓

Question 2. This question uses a numerical example to understand the connections between the
goods, money, and foreign exchange (FX) markets. Use the information in the table below
to answer the questions that follow.

Goods Market Money Market FX Market

C = 300 + 0.8(Y 9 T) T = 400 M = 1050 E e =2
I = 400 9 2,000i (πe = 0) L = 0.5Y − 5,000i i* = 8%
G = 500 P =2
TB = 400(1 9 2/E) 9 0.2(Y 9 100)

MPCF , MPCH
a. Find the MPC, and MPS for this economy.
,

Answer: MPC =0.8, MPS =0.2; MPCF =0.2, MPCH =0.6.

b. Using the uncovered interest parity condition, solve for the exchange rate (E) as a
function of the home interest rate (i).
Answer: UIP condition:
i =i* + C Ee /E - 13
i =0.08 + 2/E -
1 C 1- 2/E 3 =0.08
- i E =2/ C 0.92 +
i3
c. Write out an expression for the IS and LM curves. You should have output (Y)
expressed as a function of the interest rate (i).
Answer: IS: Y =C + I + G + TB
Y =300 + 0.8C Y - 4003 + 400 - 2, 000i + 500 + 400 C 1- 2/E 3 - 0.2 C Y - 1003
Y =300 + 0.8Y - 320 + 400 - 2, 000i + 500 + 400 C 0.08 - i3 - 0.2Y + 20
Y =932 + 0.6Y - 2, 400i
0.4Y =932 - 2, 400i
Y =2, 330 - 6, 000i
LM : M /P =L C i,Y 3
1, 050/2 =0.5Y - 5, 000i
525 =0.5Y - 5000i
0.5Y =525 + 5, 000i
Y =1, 050 +10, 000i
d. Find the equilibrium (home) interest rate, i, and the equilibrium (home) output, Y.
Calculate consumption, investment, trade balance, and exchange rate at the
economy’s equilibrium.
Answer: We can find the equilibrium at the intersection of the IS‒LM curves:

Downloaded by niguse tesfaye (nigust29@gmail.com)

 2

Downloaded by niguse tesfaye (nigust29@gmail.com)

 Y =2, 330 - 6, 000i =1, 050 +10, 000i =Y
2, 330 - 6, 000i =1, 050 +10, 000i
1, 280 =16, 000i
i =0.08 =8%
To find equilibrium output, we can plug this value into either the IS or LM curve:
Y =2, 330 - 6, 000 C 0.083 =1,850
IS:
Y =1, 050 +10, 000 C 0.083 =1,850
LM:
To find the other equilibrium values, use the expressions given in the question:
C =300 + 0.8C1,850 - 4003 =1, 460
I =400 - 2, 000 C 0.083 =240
To find the exchange rate, note from UIP:
E =2/ C 0.92 + i 3 =2/ C 0.92 + 0.083 =2
TB =400 C 1- 2/E 3 - 0.2 C1,850 - 1003
TB =400 C 1- 2/23 - 0.2 C1,850 - 1003
TB =0 - 0.2 C1,850 - 1003 =- 350

e. Suppose the government wants to achieve a balanced budget by adjusting taxes. What
level of taxes would balance the budget? Repeat (a) and (d) using this new level of taxes,
assuming a floating exchange rate regime.
Answer: If T =500 , then G =500 =T . The new IS curve is
Y =300 + 0.8C Y - 5003 + 400 - 2, 000i + 500 + 400 C1 - 2/E 3 - 0.2 C Y - 1003
Y =300 + 0.8Y - 400 + 400 - 2, 000i + 500 + 400 C 0.08 - i 3 - 0.2Y + 20
Y =852 + 0.6Y - 2, 400i
0.4Y =852 - 2, 400i
Y =2,130 - 6, 000i
To find equilibrium output, we can plug this value into either the IS or LM curve:
Y =2,130 - 6, 000 C 0.06753 =1, 725
IS:
Y =1, 050 +10, 000 C 0.06753 - =1, 725
LM:
To find the other equilibrium values, use the expressions given in the question:
C =300 + 0.8C1, 725 - 5003 =1,
(C decreased from 1,460)
280
I =400 - 2, 000 C 0.06753 =265
(I increased from 240)
To find the exchange rate, note from UIP:
E =2/ C 0.92 + i3 =2/ C 0.92 + 0.06753 =2.0253
TB =400 C 1- 2/2.02533 - 0.2 C1, 725 - 1003
TB =5 - 0.2 C1, 725 - 1003 =-
(TB increased from 9350)
320
f. Using the IS‒LM‒FX model, illustrate how this change in taxes affects the economy.
Comparing the numerical values you found in (e) with those from (d), are your answers
3

Downloaded by niguse tesfaye (nigust29@gmail.com)

 consistent with the diagram?
Answer: See the following diagram. Yes, the changes noted previously are consistent
with the implications from the model: Y ↓, i ↓, E ↑, C ↓, I ↑, TB ↑.

g. Now, suppose that monetary policy is implemented to stabilize output. Find the new
level of money supply that will allow the economy to maintain the same level of output
with increased taxes. Calculate the new values for Y, i, E, C, I, and TB.
Answer: To determine the value of M that will return the economy to Y = 1,850, we
need to find which interest rate along the new IS curve will support this value of output.
From the new IS curve:
IS2 : Y =2,130 - 6, 000i
1,850 =2,130 - 6, 000i
i =4.67%
Plugging Y and I = 4.67% into the LM curve expression will reveal which value
=1,850
of M will support this combination of output and interest rate along the new IS curve:
LM : M /P =L C i,Y 3
M /2 =0.5C1,8503 - 5, 000 C 0.04673
M =2C 925 - 233.333 =1, 383.34
Therefore, the new LM curve is
1383.34/2 =0.5Y - 5, 000i
Y =1, 383.34 +10, 000i
Checking that the new equilibrium is where IS and LM intersect at Y = 1,850 and
I =4.67% :
2,130 - 6, 000i =1, 383.34 +10, 000i
746.67 =16, 000i
i =0.0466 =4.67%
Substituting this interest rate into the IS or LM curve gives
IS : Y =2,130 - 6, 000 C 0.04673 =1,850
LM : Y =1,383.34 +10, 000C 0.04673 =1,850

4
Downloaded by niguse tesfaye (nigust29@gmail.com)
 Now we can calculate the new equilibrium values of consumption, investment, the
exchange rate, and the trade balance.
C =300 + 0.8C1,850 - 5003 =1, 380
(C decreased from 1,460)
I =400 - 2, 000 C 0.04673 =306.7
(I increased from 240)
To find the exchange rate, note from UIP:
E =2/ C 0.92 + i 3 =2/ C 0.92 + 0.04673 =2.06897
TB =400 C 1- 2/2.068973 - 0.2 C1,850 - 1003
TB =13.3 - 350 =- (TB increased from 9350)
336.7
h. Using the IS‒LM‒FX model, illustrate how the combination of the tax increase and
monetary stabilization policy affects the economy. Comparing the numerical values
you found in (g) with those from (d), are your answers consistent with the diagram?
Answer: See the following diagram. Yes, the changes noted previously are consistent
with the implications from the model: Y unchanged, i ↓, E ↑, C ↓ (because T decreased),
I
↑, TB ↑.

Question 3. The Bulgarian lev is currently pegged to the euro. Using IS‒LM diagrams for Home
(Bulgarian lev) and Foreign (Eurozone), illustrate how each of the following scenarios affects the
Bulgarian lev. Assume that this fixed exchange rate regime involves noncooperative adjustments
to interest rates and that the Eurozone is the center “country.”
a. Bulgaria increases government spending to finance social welfare programs.
Answer: The increase in government spending leads to a rightward shift in the IS curve.
This leads to an increase in the home country’s interest rate and an implied appreciation
in the home currency, shifting IS* to the left. In a fixed exchange rate regime, the home
country’s central bank shifts LM to the right to offset the increase in the home interest
rate and IS* does not shift.
Floating (B): Y ↑, i ↑, E ↓
Fixed (C): Y ↑; i and E unchanged

5
Downloaded by niguse tesfaye (nigust29@gmail.com)
b. The Eurozone countries decrease the money supply.
Answer: The decrease in foreign money supply leads to a leftward shift in the LM* curve.
This leads to an increase in the foreign country’s interest rate, i*, and an implied
appreciation in the foreign currency, shifting IS to the right. In a fixed exchange rate
regime, the home country’s central bank shifts LM to the left to align home interest rate i
with the foreign interest rate i*, shifting IS* to the right.
Floating (B): Y ↑, i ↑, E ↑
Fixed (C): Y ↓, i ↑, E unchanged

c. Investors expect a depreciation in the Bulgarian lev relative to the euro.

Answer: This increases the return on foreign deposits, leading to a depreciation in the
home currency, shifting IS to the right. The result is an increase in home interest rates,
which shifts IS* to the left. In a fixed exchange rate regime, the home country’s central
bank shifts LM to the left to prevent the depreciation and the home interest rate, i, rises,
shifting IS* further to the right. Note that the interest rates may not be equal as long as
investors expect a depreciation, i > i*.
Floating (B): Y ↑, i ↑, E ↑
Fixed (C): Y ↓, i ↑, E unchanged

Downloaded by niguse tesfaye (nigust29@gmail.com)

 7

Downloaded by niguse tesfaye (nigust29@gmail.com)