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.

Work It Out, Chapter 18, Question 2

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

(Speaker)
We assume investors expect an appreciation of the domestic currency in the future. Draw the equilibrium in the IS–LM and FX models. Remember that the domestic return DR1 corresponds to the domestic interest rate IH1.

(Description)
Two initial graphs from question a are shown.

(Speaker)
Since the investors expect an appreciation in the domestic currency, they will start buying it. This will lead to a shift in the FR curve to the left, an appreciation of the domestic currency, and therefore to an increase in the price of domestic products (relative to the foreign consumer).

(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 FR subscript 2. It has the same slope as line, FR subscript 1, but it is below this line. Point, E 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. Another straight line which is parallel to the horizontal axis is drawn. It is below line, DR subscript 1. It intersects with line, FR subscript 2, at point B.

(Speaker)
Because of the increase in price, foreigners will buy fewer domestic products and the domestic country exports will fall. This leads to a shift to the left of the IS curve.

(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 2. It has the same slope as line, IS subscript 1, but it is below this line. Point, i subscript h2, is labeled on the vertical axis. There are dotted lines drawn from some point 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.

(Speaker)
Since output decreases, so does consumption, but because interest rates decrease, investment increases. Since the domestic currency appreciates, domestic exports decrease, and the trade balance will decrease.

Work It Out, Chapter 18, Question 3

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

(Speaker)
We are told that the domestic money supply decreases. Draw the equilibrium in the IS–LM and FX models. Remember that the domestic return DR1 corresponds to the domestic interest rate IH1.

(Description)
Two initial graphs from question a are drawn.

(Speaker)
Because the domestic money supply decreases, the LM curve shifts to the left and the interest rate increases (money becomes more expensive because it is scarcer).

(Description)
On the left graph, a straight line sloping upwards from the left lower corner to the right upper corner is drawn. It is labeled LM subscript 2. It has the same slope as line, LM 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, LM subscript 2 and IS subscript 1, at point B.

(Speaker)
As such, the domestic return increases too, making keeping money in the domestic country appealing. Investors will buy domestic currency and the exchange rate will decrease (the domestic currency will appreciate).

(Description)
On the right graph, 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 decreases, so does consumption, and because interest rates increase, investment also decreases. Since the domestic currency appreciates, domestic exports decrease. The fall in domestic income will lead to domestic consumers buying fewer imported goods, thus improving the trade balance. In practice, the exchange rate appreciation will outweigh the domestic income effect and the trade balance will decrease.

Work It Out, Chapter 18, Question 4

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

(Speaker)
We are told that government spending at home decreases. Draw the equilibrium in the IS–LM and FX models. Remember that the domestic return DR1 corresponds to the domestic interest rate IH1.

(Description)
The initial graphs from question a are shown.

(Speaker)
Because domestic government spending decreases, the IS curve shifts to the left and the interest rate declines, making investing in the domestic currency less attractive.

(Description)
On the left graph, a straight line sloping downward from the left upper corner to the right lower corner is drawn. It has the same slope as line, IS subscript 1, but it is below 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, LM subscript 1, and the new sloping downward line, at point B.

(Speaker)
Investors will pull their money out of the country looking for a better return, and the exchange rate will increase (domestic currency will depreciate).

(Description)
On the right graph, 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 below 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 decreases, so does consumption, but because interest rates decrease, investment increases. Since the domestic currency depreciates, domestic exports increase, and the trade balance will increase. The fall in domestic income will lead to domestic consumers buying fewer imported goods, thus improving the trade balance. Both the depreciation and the domestic income effect lead to an increase in the trade balance.