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Chapter 19. Chapter 19

Work It Out
Chapter 19
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You must read each slide, and complete any questions on the slide, in sequence.

The Danish krone is currently pegged to the euro. Using the IS–LM–FX model for Home (Denmark) and Foreign (Eurozone), illustrate how each of the following scenarios affect Denmark:

The Eurozone reduces its money supply.
Video transcript

Work It Out, Chapter 19, Question 1

(Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)

(Speaker)
The Danish krone is currently pegged to the euro. You are asked to use the IS–LM–FX model to illustrate the effects of a shock for each of the following situations. First assume that the Eurozone reduces its money supply. We start by drawing the x and y axes for Home’s 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 subscript H. 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)
We start by drawing the x and y axes for the foreign IS–LM model and label them.

(Description)
A coordinate plane with the horizontal x-axis and the vertical y-axis is drawn on the right part of the slide. The horizontal axis is labeled Y subscript F. The vertical axis is labeled i subscript F.

(Speaker)
Then we draw the equilibrium in the home economy 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 H1. Another straight line sloping upward from the left lower corner to the right upper corner is drawn. It is labeled LM subscript H1. 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 H1 and LM subscript H1, intersect at point A.

(Speaker)
Followed by the equilibrium in the FX model.

(Description)
On the middle plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled FR subscript 1. Point, E subscript 1, is labeled on the horizontal axis. Point, DR subscript 1, is labeled on the vertical axis. There are dotted lines extending from points, E subscript 1 and DR subscript 1, which are parallel to the vertical and horizontal axes, respectively. The intersect at point A.

(Speaker)
Remember that the domestic return, DR1, corresponds to the home interest rate, IH1.

(Description)
A dotted line extending from point, DR subscript 1, which is parallel to the horizontal axis, is drawn. It shows that point, DR subscript 1, on the middle plane, is at the same level as point, i subscript H1, on the left plane.

(Speaker)
Finally, we draw the equilibrium in the foreign economy IS–LM 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 IS subscript F1. Another straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript F1. Point, Y subscript F1, is labeled on the horizontal axis. Point, i subscript F1, is labeled on the vertical axis. There are dotted lines extending from points, Y subscript F1 and i subscript F1, which are parallel to the vertical and horizontal axes, respectively. They intersect at point A. Lines, IS subscript F1 and LM subscript F1, intersect at point A.

(Speaker)
Here the foreign interest rate also corresponds to DR1 (recall the interest rates of the fixed countries must be the same). When the Eurozone reduces its money supply (LM shift), the interest rate in the foreign economy increases. Accordingly, the foreign return shifts to FR2.

(Description)
On the left plane, a straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript H2. It has the same slope as line, LM subscript H1, but it is above this line. Point, i subscript H2, is labeled on the vertical axis. A dotted line, which is parallel to the horizontal axis, extends from this point. It intersects with line, LM subscript H2, at point B. On the middle plane, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled FR subscript 2. It has the same slope as line, FR subscript 1, but it is above this line. Point, DR subscript 2, is labeled on the vertical axis. A dotted line, which is parallel to the horizontal axis, extends from this point. It intersects with line, FR subscript 2, at point B. On the right plane, a straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript F2. It has the same slope as line, LM subscript F1, but it is above this line. Point, i subscript F2, is labeled on the vertical axis. Point, Y subscript F2, is labeled on the horizontal axis. There are dotted lines drawn from point, Y subscript F2, on the horizontal axis, which is parallel to the vertical axis, as well as from point, i subscript F2, on the vertical axis, which is parallel to the horizontal axis. These dotted lines intersect with line, LM subscript F2, at point B.

(Speaker)
To prevent an increase in the exchange rate, the home country (Denmark) has to also increase its interest rates. To do this Denmark will also reduce money supply. Its output will also decrease due to increases in the interest rates.

Denmark cuts government spending to reduce its budget deficit.
Video transcript

Work It Out, Chapter 19, Question 2

(Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)

(Speaker)
We assume Denmark cuts government spending to reduce its budget deficit. Draw the equilibrium in the home IS–LM, FX, and foreign IS–LM models.

(Description)
Three graphs from part a are drawn.

(Speaker)
Remember that the domestic return, DR1, corresponds to the home interest rate, iH1, and to the foreign economy interest rate, iF1. Since the Denmark government cuts spending, the IS curve will shift. Without intervention, interest rates will decrease, the exchange rate will change, and output will decrease from Y1 to Y2.

(Description)
On the left graph, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled iS subscript H2. It has the same slope as line, iS subscript H1, but it is below this line. Point, Y subscript 2, is labeled on the horizontal axis. A dotted line, which is parallel to the vertical axis, extends from this point. It intersects with line, iS subscript H2.

(Speaker)
To keep the exchange rate stable, the central bank needs to intervene. By reducing money supply, the interest rate does not change and neither does the exchange rate. However, output will decrease even more, to Y3.

(Description)
On the left graph, another straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript H2. It has the same slope as line, LM subscript H2, but it is above this line. Point, Y subscript 3, is labeled on the horizontal axis. A dotted line, which is parallel to the vertical axis, extends from this point. It intersects with lines, iS subscript H2, and, LM subscript H2, at point B.

The Eurozone countries increase their taxes.
Video transcript

Work It Out, Chapter 19, Question 3

(Transcript of audio with descriptions. Transcript includes narrator headings and description headings of the visual content)

(Speaker)
We are told that the Eurozone countries raise taxes. Draw the equilibrium in the home IS–LM, FX, and foreign IS–LM models.

(Description)
Three graphs from part a are drawn.

(Speaker)
Remember that the domestic return, DR1, corresponds to the home interest rate, iH1, and to the foreign economy interest rate, if1. Because foreign taxes increase, the economy will contract, and the foreign interest rate will decrease from iF1 to iF2 (the lower interest rate lowers the FR line in the FX market).

(Description)
On the right graph, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled iS subscript F2. It has the same slope as line, iS subscript F1, but it is below this line. Point, i subscript F2, is labeled on the vertical axis. It is below the point, i subscript F2. A dotted line, which is parallel to the horizontal axis, extends from point, i subscript F2. It intersects with lines, iS subscript F2, and, LM subscript F1.

(Speaker)
Accordingly, the lower foreign interest rate will put the home exchange rate under pressure to decrease (the currency wants to appreciate).

(Description)
On the middle graph, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled FR subscript 2. It has the same slope as line, FR subscript 2, but it is below this line. Point, DR subscript 2, is labeled on the vertical axis. It is below the point, DR subscript 1. A dotted line, which is parallel to the horizontal axis, extends from point, DR subscript 2. It intersects with lines, FR subscript 2, and, FR subscript 1, from the left to the right, respectively.

(Speaker)
Due to a decrease in imports from the Eurozone, the home IS curve will shift and the interest rate will tend to decline.

(Description)
On the left graph, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It is labeled IS subscript H2. It has the same slope as line, IS subscript H1, but it is below this line. Point, i subscript H2, is labeled on the vertical axis. It is below the point, i subscript H1. A dotted line, which is parallel to the horizontal axis, extends from point, i subscript H2. It intersects with lines, LM subscript H1, IS subscript H2, and IS subscript H1, from the left to the right, respectively.

(Speaker)
However, the decline will be relatively small. To bring the home interest rates in line with the foreign interest rates, and thus keep the exchange rate fixed, the central bank has to reduce interest rates further. It will increase money supply, and income will actually increase from Y1 to Y2.

(Description)
On the left graph, another straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript H2. It has the same slope as line, LM subscript H1, but it is below this line. Point, Y subscript 2, is labeled on the horizontal axis. It is to the right of the point, Y subscript 1. A dotted line, which is parallel to the horizontal axis, extends from point, Y subscript 2. It intersects with lines, LM subscript H2, and, IS subscript H2, at point B.

(Speaker)
In practical terms, what happens to output in the home country depends on the relative size of the shifts of the curves.