Macroeconomics, 6e (Blanchard/Johnson)

Chapter 20: Output, the Interest Rate, and the Exchange Rate

20.1 Multiple Choice Questions

1) Assume that the price levels in two countries are constant. In this situation, we know that
A) neither the real nor the nominal exchange rate can change.
B) the real exchange rate can change, while the nominal exchange rate is constant
C) the nominal exchange rate can change, while the real exchange rate is constant.
D) the real and nominal exchange rate must move together, changing by the same percentage.
E) the nominal exchange rate will fluctuate more widely than the real exchange rate.
Answer: D
Diff: 1

2) An increase in the real exchange rate will cause

A) an increase in net exports.
B) an increase in the quantity of imports.
C) an increase in output.
D) a decrease in government spending.
E) all of the above
Answer: B
Diff: 1

3) In order for an individual to be indifferent between holding foreign or domestic bonds,

A) the Marshall-Lerner condition must hold.
B) the foreign and domestic interest rates must be equal.
C) the expected rate of depreciation of the domestic currency is zero.
D) the interest parity condition must hold.
Answer: D
Diff: 1

4) The interest parity condition indicates that the domestic interest rate must be equal to
A) the foreign interest rate.
B) the expected rate of depreciation of the domestic currency.
C) the expected rate of appreciation of the domestic currency.
D) the foreign interest rate minus the expected rate of appreciation of the foreign currency.
E) none of the above
Answer: E
Diff: 1

1
Copyright © 2013 Pearson Education, Inc.
5) Assume that the interest parity condition holds. Also assume that the U.S. interest rate is 8%
while the U.K. interest rate is 6%. Given this information, financial markets expect the pound to
A) depreciate by 14%.
B) depreciate by 2%.
C) appreciate by 2%.
D) appreciate by 6%.
E) appreciate by 14%.
Answer: C
Diff: 2

6) Assume that the interest parity holds and that the dollar is expected to depreciate against the
pound. Given this information, we know that
A) U.S. and U.K. interest rates are equal.
B) the U.S. interest rate exceeds the U.K. interest rate.
C) the U.K. interest rate exceeds the U.S. interest rate.
D) individuals will prefer to hold U.S. bonds because the U.S. interest rate exceeds the U.K.
interest rate.
E) none of the above
Answer: B
Diff: 2

7) In an open economy, we know that individuals must choose between which of the following?
A) domestic bonds and foreign currency
B) foreign goods and domestic currency
C) domestic and foreign bonds
D) domestic goods and foreign currency
E) none of the above
Answer: C
Diff: 1

8) A real appreciation will tend to cause

A) an increase in exports.
B) a reduction in imports.
C) an increase in net exports.
D) a reduction in demand for domestic goods.
E) none of the above
Answer: D
Diff: 1

2
Copyright © 2013 Pearson Education, Inc.
9) As the economy moves up and to the left along the IS curve, which of the following will occur
when exchange rates are flexible?
A) investment spending decreases
B) consumption decreases
C) the domestic currency appreciates
D) all of the above
E) none of the above
Answer: D
Diff: 1

10) In an open economy under flexible exchange rates, a reduction in the interest rate will cause
a reduction in which of the following?
A) investment
B) the exchange rate, E
C) net exports
D) all of the above
E) none of the above
Answer: B
Diff: 2

11) In an open economy under flexible exchange rates and represented by the IS-LM-IP model, a
reduction in government spending will cause a reduction in which of the following?
A) net exports
B) the exchange rate, E
C) exports
D) all of the above
E) none of the above
Answer: C
Diff: 2

12) In an open economy under flexible exchange rates, a reduction in consumer confidence that
causes a reduction in consumption will cause which of the following?
A) an appreciation of the domestic currency
B) a reduction in the exchange rate, E
C) a reduction in net exports
D) all of the above
E) none of the above
Answer: A
Diff: 2

3
Copyright © 2013 Pearson Education, Inc.
13) In an open economy under flexible exchange rates, expansionary monetary policy that results
in an increase in the money supply will always cause
A) an increase in output.
B) an increase in exports.
C) a reduction in the exchange rate, E.
D) all of the above
E) only A and C
Answer: D
Diff: 2

14) Assume that the interest parity condition holds and that both the expected exchange rate and
foreign interest rate are constant. Given this information, a reduction in the domestic interest rate
will cause
A) a reduction in the exchange rate expected in the future.
B) a reduction in the current exchange rate.
C) greater depreciation of the domestic currency expected in the future.
D) all of the above
E) none of the above
Answer: B
Diff: 2

15) The exchange rate policy of the United States is

A) the EMS.
B) a crawling peg.
C) a float.
D) a fixed rate within a band.
E) none of the above
Answer: C
Diff: 1

16) Suppose a country with a fixed exchange rate decides to reduce the price of its currency. This
change in policy is called
A) an appreciation.
B) a depreciation.
C) a peg.
D) a devaluation.
E) a revaluation.
Answer: E
Diff: 1

4
Copyright © 2013 Pearson Education, Inc.
17) Under a "crawling peg" system, a country's exchange rate
A) is fixed except for small, surprise changes.
B) changes at a predetermined rate against the dollar or some other major currency.
C) can fluctuate within a narrow band.
D) can change, but the changes are kept secret from the public.
E) is determined by the central bank of another country.
Answer: B
Diff: 1

18) In 2005, China increased the price of its currency while continuing to pursue a fixed
exchange rate. This change in policy is called
A) an appreciation.
B) a depreciation.
C) a peg.
D) a devaluation.
E) a revaluation.
Answer: D
Diff: 1

19) For this question, assume that the economy is operating in a fixed exchange rate regime and
that perfect capital mobility exists. Given this information, which of the following will occur?
A) the domestic and foreign interest rates must be equal.
B) the central bank cannot use monetary policy to affect domestic output.
C) an expansionary fiscal policy will require that the central bank increase the money supply.
D) all of the above
E) none of the above
Answer: D
Diff: 2

20) Suppose a country switches from a fixed to a flexible exchange rate. Which of the following
will occur as a result of this change?
A) monetary policy will become a less effective tool for changing output.
B) a given change in government spending will now have a greater effect on output.
C) both fiscal and monetary policy will become more effective in changing GDP.
D) both fiscal and monetary policy will become completely ineffective in changing GDP.
E) none of the above
Answer: E
Diff: 2

5
Copyright © 2013 Pearson Education, Inc.
21) A common argument for fixed exchange rates is that they
A) give central banks greater freedom in adjusting their economy's level of output.
B) forever free the central bank from have to adjust the exchange rate to fundamental changes in
the economy.
C) make trade more costly, and thus encourage domestic citizens to buy domestically produced
output.
D) all of the above
E) none of the above
Answer: E
Diff: 1

22) In practice, under the EMS, a member country

A) could never change its interest rate.
B) could change its interest rate only if other countries changed theirs as well.
C) must apply to a special European Commission in order to change its interest rate.
D) had complete freedom in choosing the interest rate it wanted.
E) had complete freedom in choosing its interest rate only if it is a very small country.
Answer: B
Diff: 1

23) In the early 1990s, which nation took the lead in driving up European interest rates?
A) Spain
B) France
C) Germany
D) England
E) none of the above
Answer: E
Diff: 1

24) In the early 1990s, European unemployment rose largely because of

A) reductions in stock prices.
B) undervalued currencies.
C) overvalued currencies.
D) high inflation
E) none of the above
Answer: A
Diff: 1

6
Copyright © 2013 Pearson Education, Inc.
25) Assume that the current exchange rate between U.K. pound and the U.S. dollar is 2 (E = 2.0).
If interest parity holds, and the U.S. interest rate is 6% while the U.K. interest rate is 8%, the
expected exchange rate in one year is
A) 1.98.
B) 1.99.
C) 2.01.
D) 2.02.
E) 2.04.
Answer: C
Diff: 2

26) For this question, assume that there is a simultaneous tax increase and monetary expansion.
In a flexible exchange rate regime, we know with certainty that
A) the exchange rate and output would both increase.
B) the exchange rate would increase and output would decrease.
C) the exchange rate would decrease.
D) the exchange rate would decrease and output would increase.
E) none of the above
Answer: C
Diff: 2

27) For this question, assume that there is a simultaneous increase in government spending and
monetary contraction. In a flexible exchange rate regime, we know with certainty that such a
policy mix will cause which of the following?
A) an increase in the domestic interest rate
B) an increase in the exchange rate
C) a reduction in net exports
D) all of the above
E) only A and C
Answer: D
Diff: 2

28) Assume policy makers in a fixed exchange rate regime decide to peg the exchange rate at a
higher level. This is called
A) a devaluation.
B) a revaluation.
C) a depreciation.
D) an appreciation.
Answer: A
Diff: 1

7
Copyright © 2013 Pearson Education, Inc.
29) Assume policy makers in a fixed exchange rate regime decide to peg the exchange rate at a
lower level. This is called
A) a devaluation.
B) a revaluation.
C) a depreciation.
D) an appreciation.
Answer: B
Diff: 1

30) The European Monetary System represented a

A) exchange rate regime with 'bands.'
B) crawling peg.
C) a flexible exchange rate regime.
D) none of the above
Answer: A
Diff: 1

31) Suppose policy makers are pursuing a policy to fix the exchange rate. In such a system with
perfect capital mobility, an open market purchase of domestic bonds by the domestic central
bank will eventually result in
A) a permanent increase in the monetary base.
B) a permanent reduction in the monetary base.
C) a change in the composition of the monetary base.
D) a gradual reduction in the domestic interest rate.
Answer: C
Diff: 2

32) Suppose policy makers are pursuing a policy to fix the exchange rate. In such a system with
perfect capital mobility, an open market sale of domestic bonds by the domestic central bank will
eventually result in
A) a permanent increase in the monetary base.
B) a permanent reduction in the monetary base.
C) a gradual reduction in the domestic interest rate.
D) a change in the composition of the monetary base.
Answer: D
Diff: 2

33) Suppose a country is pursuing a fixed exchange rate regime with imperfect capital mobility.
The ability of that country to move its domestic interest rate while maintaining its exchange rate
will depend on
A) the degree of development of its financial markets.
B) the degree of capital controls.
C) the amount of foreign exchange it holds.
D) all of the above
E) both A and B
Answer: D
Diff: 2
8
Copyright © 2013 Pearson Education, Inc.
34) Under a fixed exchange rate regime, the central bank must act to keep
A) P = P*.
B) the real exchange rate fixed.
C) i = i*.
D) E = 1.
E) none of the above
Answer: A
Diff: 2

35) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now
suppose that an increase in stock market wealth causes an increase in consumption. Which of the
following will tend to occur in a fixed exchange rate regime?
A) an increase in Y
B) an increase in the money supply
C) no change in the domestic interest rate
D) all of the above
Answer: D
Diff: 2

36) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now
suppose that households decide to decrease consumption because of, for example, a reduction in
consumer confidence. Given this information, we would expect which of the following to occur?
A) a reduction in the domestic interest rate
B) an increase in E
C) a reduction in E
D) a reduction in investment
E) none of the above
Answer: D
Diff: 2

37) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now
suppose a budget is passed that calls for a reduction in government spending. This reduction in
government spending will cause which of the following to occur?
A) a reduction in i and an increase in E
B) a reduction in investment
C) no change in output
D) no change in net exports
E) an increase in imports
Answer: B
Diff: 2

9
Copyright © 2013 Pearson Education, Inc.
38) Under a fixed exchange rate regime, suppose there is a reduction in housing wealth that
causes a reduction in consumption. This wealth-induced reduction in consumption will cause
A) a reduction in investment.
B) an increase in net exports.
C) a reduction in imports.
D) all of the above
E) none of the above
Answer: D
Diff: 2

39) Under a fixed exchange rate regime, expansionary fiscal policy will tend to cause which of
the following?
A) an increase in imports
B) an increase in net exports
C) a reduction in investment
D) all of the above
Answer: A
Diff: 2

40) In a flexible exchange rate regime, an increase in the foreign interest rate (i*) will cause
A) the IP curve to shift to the left/up.
B) the IP curve to shift to the right/down.
C) a movement along the IP curve.
D) neither a shift nor movement along the IP curve.
Answer: B
Diff: 3

41) In a flexible exchange rate regime, a reduction in the foreign interest rate (i*) will cause
A) the IP curve to shift to the left/up
B) the IP curve to shift to the right/down
C) a movement along the IP curve
D) neither a shift nor movement along the IP curve
Answer: A
Diff: 3

42) In a flexible exchange rate regime, an increase in the expected future exchange rate will
cause
A) the IP curve to shift to the left/up.
B) the IP curve to shift to the right/down.
C) a movement along the IP curve.
D) neither a shift nor movement along the IP curve.
Answer: B
Diff: 3

10
Copyright © 2013 Pearson Education, Inc.
43) In a flexible exchange rate regime, a reduction in the expected future exchange rate will
cause
A) the IP curve to shift to the left/up.
B) the IP curve to shift to the right/down.
C) a movement along the IP curve.
D) neither a shift nor movement along the IP curve.
Answer: A
Diff: 3

44) Assume the interest parity condition holds and that initially i = i*. A reduction in the
domestic interest rate will cause
A) an increase in the demand for the domestic currency.
B) a reduction in E.
C) an expected depreciation of the domestic currency.
D) all of the above
Answer: D
Diff: 2

45) Assume the interest parity condition holds and that initially i = i*. A reduction in the foreign
interest rate (i*) will cause
A) an increase in the demand for the domestic currency.
B) an increase in E.
C) an expected depreciation of the domestic currency.
D) all of the above
Answer: C
Diff: 3

46) Contractionary monetary policy in a flexible exchange rate regime will cause
A) a shift of the IP curve.
B) a depreciation of the domestic currency.
C) an increase in E.
D) no change in E.
Answer: C
Diff: 1

47) Suppose there are two countries that are identical in every way with the following exception.
Country A is pursuing a fixed exchange rate regime and country B is pursuing a flexible
exchange rate regime. Suppose taxes are increased in both countries rises by the same amount.
Given this information, we know that
A) the change in output in A will be greater than in B.
B) the change in output in B will be greater than in A.
C) the change in output will be the same in both countries.
D) the relative output effects are ambiguous.
Answer: A
Diff: 3

11
Copyright © 2013 Pearson Education, Inc.
48) A reduction in the real exchange rate will cause
A) a reduction in net exports.
B) a reduction in the quantity of imports.
C) a reduction in output.
D) an increase in government spending.
E) all of the above
Answer: B
Diff: 1

49) Assume that the interest parity condition holds. Also assume that the U.S. interest rate is 6%
while the U.K. interest rate is 8%. Given this information, financial markets expect the pound to
A) depreciate by 14%.
B) depreciate by 2%.
C) appreciate by 2%.
D) appreciate by 6%.
E) appreciate by 14%.
Answer: B
Diff: 2

50) Assume that the interest parity holds and that the dollar is expected to appreciate against the
pound. Given this information, we know that
A) U.S. and U.K. interest rates are equal.
B) the U.S. interest rate exceeds the U.K. interest rate.
C) the U.K. interest rate exceeds the U.S. interest rate.
D) individuals will prefer to hold U.S. bonds because the U.S. interest rate exceeds the U.K.
interest rate.
E) none of the above
Answer: C
Diff: 2

51) A real depreciation will tend to cause

A) a reduction in exports.
B) an increase in imports.
C) a reduction in net exports.
D) an increase in demand for domestic goods.
E) none of the above
Answer: D
Diff: 1

12
Copyright © 2013 Pearson Education, Inc.
52) As the economy moves up and to the right along the IS curve, which of the following will
occur when exchange rates are flexible?
A) investment spending increases
B) consumption increases
C) the domestic currency depreciates
D) all of the above
E) none of the above
Answer: D
Diff: 1

53) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now
suppose that a reduction in stock market wealth causes a decrease in consumption. Which of the
following will tend to occur in a fixed exchange rate regime?
A) a reduction in Y
B) a reduction in the money supply
C) no change in the domestic interest rate
D) all of the above
Answer: D
Diff: 2

54) For this question, assume that policy makers are pursuing a fixed exchange rate regime. Now
suppose that households decide to increase consumption because of, for example, an increase in
consumer confidence. Given this information, we would expect which of the following to occur?
A) an increase in the domestic interest rate
B) a reduction in E
C) an increase in E
D) an increase in investment
E) none of the above
Answer: D
Diff: 2

55) Under a fixed exchange rate regime, suppose there is an increase in housing wealth that
causes an increase in consumption. This wealth-induced increase in consumption will cause
A) an increase in investment.
B) a reduction in net exports.
C) an increase in imports.
D) all of the above
E) none of the above
Answer: D
Diff: 2

13
Copyright © 2013 Pearson Education, Inc.
56) Under a fixed exchange rate regime, contractionary fiscal policy will tend to cause which of
the following?
A) a reduction in imports
B) a reduction in net exports
C) an increase in investment
D) all of the above
Answer: A
Diff: 2

57) Expansionary monetary policy in a flexible exchange rate regime will cause
A) a shift of the IP curve.
B) an appreciation of the domestic currency.
C) a reduction in E.
D) no change in E.
Answer: C
Diff: 1

20.2 Essay Questions

1) In an economy operating under flexible exchange rates, explain why the IS curve is downward
sloping.
Answer: A reduction in i (assume zero inflation) will cause investment to increase for reasons
discussed before. This causes an increase in Z and Y. There is a second effect now embedded in
the IS curve. As i falls, the demand for the domestic currency drops causing a depreciation. This
depreciation causes NX to rise and demand to rise even more. So, there are two components of
demand that now change as i changes: I and NX.

2) Explain what the IP curve is and why it is upward sloping.

Answer: The IP curve represents the combinations of i and E that maintain the interest parity
condition. As i falls, foreign bonds will have a higher expected return. The demand for the dollar
will fall causing an immediate depreciation. So, the drop in i causes E to fall. E will fall until all
of the drop in i is offset by the expected appreciation of the dollar.

3) Suppose the domestic and foreign interest rates are both initially equal to 3%. Now suppose
the domestic interest rate rises to 5%. Explain what effect this will have on the exchange rate.
Also explain what must occur for the interest parity condition to be restored.
Answer: Domestic bonds will have a higher return causing the demand for the domestic
currency to rise. The dollar will appreciate. It will continue to appreciate as long as the return on
domestic bonds exceeds the return on foreign bonds. This immediate appreciation will equal an
expected depreciation of the domestic currency that equates the expected returns. So, the dollar
will appreciate by 2%.

14
Copyright © 2013 Pearson Education, Inc.
4) Suppose the domestic and foreign interest rates are both initially equal to 4%. Now suppose
the foreign interest rate rises to 6%. Explain what effect this will have on the exchange rate. Also
explain what must occur for the interest parity condition to be restored.
Answer: Domestic bonds will have a lower return causing the demand for the domestic currency
to fall. The dollar will depreciate. It will continue to depreciate as long as the return on
domestic bonds is less than the return on foreign bonds. This immediate depreciation will equal
an expected appreciation of the domestic currency that equates the expected returns. So, the
dollar will depreciate by 2%.

5) Explain what effect each of the following events will have on the IS curve in a flexible
exchange rate regime: (1) an increase in foreign output; (2) a reduction in the foreign interest
rate; and (3) an increase in the domestic interest rate.
Answer: An increase in Y* causes X to rise, Z to rise, and the IS curve to shift to the right. A
reduction in i* will cause an appreciation of the domestic currency, a reduction in NX, and a
leftward shift in the IS curve. A change in i will only cause a movement along the IS curve.

6) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect an increase in government spending will have on
the domestic economy. In your graphs, clearly label all curves and equilibria.
Answer: An increase in G will cause Z to increase and the IS curve to shift right. As demand
increases, Y will rise causing an increase in money demand. The increase in money demand will
cause an increase in i. As i rises, the demand for the domestic currency will increase causing an
appreciation. This appreciation will cause a drop in NX. Any drop in I and the reduction in NX
only partially offset the effects of the increase in G on demand and output.

7) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect monetary contraction will have on the domestic
economy. In your graphs, clearly label all curves and equilibria.
Answer: A reduction in M will cause the LM curve to shift up and the domestic interest rate to
rise. As i rises, the return on domestic bonds is greater than foreign bonds. This causes an
appreciation and a reduction in NX. So, the demand for goods falls via the drop in I and NX. We
will observe a higher domestic interest rate, an increase in E, a drop in I, a reduction in NX, and
a reduction in Y.

8) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect a reduction in foreign output (Y*) will have on the
domestic economy. In your graphs, clearly label all curves and equilibria.
Answer: A reduction in Y* will cause a reduction in X and NX. This causes the IS curve to shift
to the left. As demand falls, production will drop. The drop in Y will cause a reduction in money
demand. As money demand falls, i will fall causing a depreciation. So, some of the effects of Y*
on NX will be offset by the increase in NX caused by the depreciation. We will observe a
reduction in NX, a reduction in Y, a reduction in i, and a reduction in E.

15
Copyright © 2013 Pearson Education, Inc.
9) For a country pursuing a fixed exchange rate regime, what does the interest parity condition
imply about domestic and foreign interest rates? Explain.
Answer: As long as the fixed exchange rate regime is credible, the interest rates must be equal.
If the exchange rate regime is credible, we know that there will be no expected appreciation or
depreciation so i = i*.

10) To what extent can monetary policy be used to affect output in a fixed exchange rate regime?
Explain.
Answer: It cannot. To peg the exchange rate, the central bank must keep the domestic interest
rate equal to the exogenous foreign interest rate. The domestic central bank cannot independently
change its interest rate.

11) Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate and explain
what effect a reduction in consumer confidence will have on the domestic economy. In your
graphs, clearly label all curves and equilibria.
Answer: A reduction in consumer confidence will cause a drop in C and will cause demand to
fall and the IS curve to shift to the left. As Y falls, money demand will fall and the domestic
interest rate will tend to fall. If i falls, there will be tremendous pressure on the domestic
currency to depreciate as demand falls. The central bank cannot let this occur. To prevent this, it
must reduce the money supply so that i does not fall. We will observe a drop in Y, no change in i,
a reduction in I (via the drop in I), and an increase in NX caused by the drop in imports.

12) Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the
foreign interest rate increases. Discuss what policy makers must do to maintain the pegged
exchange rate. Also discuss what effect this will have on domestic output and net exports.
Answer: If i* increases, there will be pressure on the domestic currency to depreciate. To
prevent this, the domestic central bank must raise its interest rate so that it rises by the same
amount as i*. In this case, the LM curve will shift up so that the new equilibrium interest rate is
equal to the now higher foreign interest rate. As i rises, E does not change. However, I will fall
causing a reduction in demand and output. As Y falls, imports will fall and NX will increase.

13) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect a reduction in government spending will have on
the domestic economy. In your graphs, clearly label all curves and equilibria.
Answer: A reduction in G will cause Z to decrease and the IS curve to shift left. As demand
decreases, Y will fall causing a decrease in money demand. The decrease in money demand will
cause an decrease in i. As i falls, the demand for the domestic currency will decrease causing a
depreciation. This depreciation will cause a rise in NX. Any increase in I and the increase in NX
only partially offset the effects of the reduction on demand and output.

16
Copyright © 2013 Pearson Education, Inc.
14) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect monetary expansion will have on the domestic
economy. In your graphs, clearly label all curves and equilibria.
Answer: An increase in M will cause the LM curve to shift down and the domestic interest rate
to fall. As i falls, the return on domestic bonds is less than foreign bonds. This causes an
depreciation and an increase in NX. So, the demand for goods rises via the increase in I and NX.
We will observe a lower domestic interest rate, a reduction in E, an increase in I, an increase in
NX, and an increase in Y.

15) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,
graphically illustrate and explain what effect an increase in foreign output (Y*) will have on the
domestic economy. In your graphs, clearly label all curves and equilibria.
Answer: An increase in Y* will cause an increase in X and NX. This causes the IS curve to shift
to the right As demand rises, production will increase. The increase in Y will cause an increase
in money demand. As money demand rises, i will rise causing an appreciation. So, some of the
effects of Y* on NX will be offset by the decrease in NX caused by the appreciation. We will
observe an increase in NX, an increase in Y, an increase in i, and an increase in E.

16) Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate and explain
what effect an increase in consumer confidence will have on the domestic economy. In your
graphs, clearly label all curves and equilibria.
Answer: An increase in consumer confidence will cause an increase in C and will cause demand
to rise and the IS curve to shift to the right. As Y rises, money demand will increase and the
domestic interest rate will tend to rise. If i rises, there will be tremendous pressure on the
domestic currency to appreciate as demand rises. The central bank cannot let this occur. To
prevent this, it must increase the money supply so that i does not rise. We will observe an
increase in Y, no change in i, an increase in I (via the increase in I), and a reduction in NX caused
by the rise in imports.

17) Assume that policy makers are pursuing a fixed exchange rate regime. Now suppose that the
foreign interest rate falls. Discuss what policy makers must do to maintain the pegged exchange
rate. Also discuss what effect this will have on domestic output and net exports.
Answer: If i* falls, there will be pressure on the domestic currency to appreciate. To prevent
this, the domestic central bank must reduce its interest rate so that it falls by the same amount as
i*. In this case, the LM curve will shift down so that the new equilibrium interest rate is equal to
the now lower foreign interest rate. As i falls, E does not change. However, I will rise causing an
increase in demand and output. As Y rises, imports will rise and NX will decrease.

17
Copyright © 2013 Pearson Education, Inc.