PROBLEMS

1. Using the IS-LM-FX model, illustrate how each of the following scenarios affects the home country. Compare the outcomes when the home country has a fixed exchange rate with the outcomes when the home currency floats.
   • The foreign country increases the money supply.
   • The home country cuts taxes.
   • Investors expect a future appreciation in the home currency.
2. The Lithuanian lita is currently pegged to the euro. Using the IS-LM-FX model for Home (Lithuania) and Foreign (Eurozone), illustrate how each of the following scenarios affect Lithuania:
   • The Eurozone reduces its money supply.
   • Lithuania cuts government spending to reduce its budget deficit.
   • The Eurozone countries increase their taxes.
3. Consider two countries that are currently pegged to the euro: Lithuania and Comoros. Lithuania is a member of the European Union, allowing it to trade freely with other European Union countries. Exports to the Eurozone account for the majority of Lithuania’s outbound trade, which mainly consists of manufacturing goods, services, and wood. In contrast, Comoros is an archipelago of islands off the eastern coast of southern Africa that exports food commodities primarily to the United States and France. Comoros historically maintained a peg with the French franc, switching to the euro when France joined the Eurozone. Compare and contrast Lithuania and Comoros in terms of their likely degree of integration symmetry with the Eurozone. Plot Comoros and Lithuania on a symmetry-integration diagram as in Figure 8-4.
4. Use the symmetry-integration diagram as in Figure 8-4 to explore the evolution of international monetary regimes from 1870 to 1939—that is, during the rise and fall of the gold standard.
   • From 1870 to 1913, world trade flows doubled in size relative to GDP, from about 10% to 20%. Many economic historians believe this was driven by exogenous declines in transaction costs, some of which were caused by changes in transport technology. How would you depict this shift for a pair of countries in the symmetry-integration diagram that started off just below the FIX line in 1870? Use the letter A to label your starting point in 1870 and use B to label the end point in 1913.
   • From 1913 to 1939, world trade flows collapsed, falling in half relative to GDP, from about 20% back to 10%. Many economic historians think this was driven by exogenous increases in transaction costs from rising transport costs and increases in tariffs and quotas. How would you depict this shift for a pair of countries in the symmetry-integration diagram that started off just above the FIX line in 1913? Use the letter B to label your starting point in 1913 and use C to label the end point in 1939.
   • Other economic historians contend that these changes in transaction costs arose endogenously. When countries went on the gold standard, they lowered their transaction costs and boosted trade. When they left gold, costs increased. If this is true, then do points A, B, and C represent unique solutions to the problem of choosing an exchange rate regime?
   • Changes in other factors in the 1920s and 1930s had an impact on the sustainability of the gold standard. These included the following:
     1. An increase in country-specific shocks
     2. An increase in democracy
     3. Growth of world output relative to the supply of gold

     In each case, explain why these changes might have undermined commitment to the gold standard.

5. Many countries experiencing high and rising inflation, or even hyperinflation, will adopt a fixed exchange rate regime. Discuss the potential costs and benefits of a fixed exchange rate regime in this case. Comment on fiscal discipline, seigniorage, and expected future inflation.
6. In the late 1970s, several countries in Latin America, notably Mexico, Brazil, and Argentina, had accumulated large external debt burdens. A significant share of this debt was denominated in U.S. dollars. The United States pursued contractionary monetary policy from 1979 to 1982, raising dollar interest rates. How would this affect the value of the Latin American currencies relative to the U.S. dollar? How would this affect their external debt in local currency terms? If these countries had wanted to prevent a change in their external debt, what would have been the appropriate policy response, and what would be the drawbacks?
7. Home’s currency is the peso and trades at 1 peso per dollar. Home has external assets of $200 billion, all of which are denominated in dollars. It has external liabilities of $400 billion, 75% of which are denominated in dollars.
   • Is Home a net creditor or debtor? What is Home’s external wealth?
   • What is Home’s net position in dollar-denominated assets?
   • If the peso depreciates to 1.2 pesos per dollar, what is the change in Home’s external wealth in pesos?
8. Evaluate the empirical evidence on how currency depreciation affects wealth and output across countries. How does the decision of maintaining a fixed versus floating exchange rate regime depend on a country’s external wealth position?
9. Home signs a free-trade agreement with Foreign, which lowers tariffs and other barriers to trade. Both countries are very similar in terms of economic shocks, as they each produce very similar goods. Use a symmetry-integration diagram as in Figure 8-4 as part of your answer to the following questions:
   • Initially, trade rises. Does the rise in trade make Home more or less likely to peg its currency to the Foreign currency? Why?
   • In the longer run, freer trade causes the countries to follow their comparative advantage and specialize in producing very different types of goods. Does the rise in specialization make Home more or less likely to peg its currency to the Foreign currency? Why?