For each of the following situations, use the IS–LM–FX model to illustrate the effects of the shock. For each case, state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y , i , E , C , I , and TB .
Note: In this question, assume the government allows the exchange rate to float and makes no policy response.
Hint: In each case, make use of the goods market equilibrium condition to understand what happens to consumption, investment, and the trade balance in the shift from the old to the new equilibrium.
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Work It Out, Chapter 18, Question 1
(Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)
(Speaker)
You are asked to use the IS–LM–FX model to illustrate the effects of the shock for each of the following situations.
For each case, we have to state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): Y (output and expansion), i (interest rate), E (exchange rate), C (consumption), I (investment), and TB (trade balance).
We assume the government allows the exchange rate to float and makes no policy response.
Hint: In each case, make use of the goods market equilibrium condition to understand what happens to consumption, investment, and the trade balance in the shift from the old to the new equilibrium.
We assume that foreign output increases.
We start by drawing the x and y axes for the IS-LM model and label them.
(Description)
A coordinate plane with the horizontal x-axis and the vertical y-axis is drawn on the left part of the slide. The horizontal axis is labeled Y. The vertical axis is labeled i subscript H.
(Speaker)
We then draw the X and Y axes for the FX model and label them.
(Description)
A coordinate plane with the horizontal x-axis and the vertical y-axis is drawn in the middle part of the slide. The horizontal axis is labeled E subscript H over F. The vertical axis is labeled Returns.
(Speaker)
Then we draw the equilibrium in the IS–LM model…
(Description)
On the left plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled IS subscript 1.
Another straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript 1.
Point, Y subscript 1, is labeled on the horizontal axis. Point, i subscript h1, is labeled on the vertical axis. There are dotted lines extending from points, Y subscript 1 and i subscript h1, which are parallel to the vertical and horizontal axes, respectively. The intersect at point A.
Lines, IS subscript 1 and LM subscript 1, intersect at point A.
(Speaker)
…followed by the equilibrium in the FX model.
(Description)
On the right plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled FR subscript 1.
Another straight line which is parallel to the horizontal axis is drawn. It is labeled DR subscript 1.
Point, E subscript 1, is labeled on the horizontal axis. There is a dotted line extending from point, E subscript 1, which is parallel to the vertical axis.
Three lines intersect at point A.
(Speaker)
Remember that the domestic return DR1 corresponds to the domestic interest rate IH1.
(Description)
A dotted line extending from point, i subscript h1, which is parallel to the horizontal axis, is drawn. It shows that point, i subscript h1, on the left plane, is at the same level as line, DR subscript 1, on the right plane.
(Speaker)
When the foreign output increases, the foreign country consumers will buy more of the domestic country products. Therefore, domestic country IS curve will shift to the right and output will increase.
Since this leads to an increase in domestic interest rates to IH2, the domestic return rates will also increase to DR2. The result is a decrease in the exchange rate to E2 (appreciation of the domestic currency).
(Description)
On the left plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled IS subscript 2. It has the same slope as line, IS subscript 1, but it is above this line.
Point, i subscript h2, is labeled on the vertical axis. Point, Y subscript 2, is labeled on the horizontal axis.
There are dotted lines drawn from point, Y subscript 2, on the horizontal axis, which is parallel to the vertical axis, as well as from point, i subscript h2, on the vertical axis, which is parallel to the horizontal axis.
These dotted lines intersect with lines, IS subscript 2, and LM subscript 1, at point B.
On the right plane, a straight line which is parallel to the horizontal axis is drawn. It is labeled DR subscript 2. It has the same slope as line, DR subscript 1, but it is above this line.
Point, E subscript 2, is labeled on the horizontal axis. There is a dotted line drawn from point, E subscript 2, on the horizontal axis, which is parallel to the vertical axis.
This dotted line intersects with lines, DR subscript 2, and FR subscript 1, at point B.
(Speaker)
Since output increases, so does consumption, but because interest rates increase, investment decreases. Since domestic exports increase, the trade balance will increase output at domestic, and the appreciation of the exchange rate will cause the trade balance to decrease. In practice the original shock (higher foreign income) will outweigh the secondary effects, and the trade balance will increase.