PROBLEMS

1. In 2001, President George W. Bush and Federal Reserve Chairman Alan Greenspan were both concerned about a sluggish U.S. economy. They also were concerned about the large U.S. current account deficit. To help stimulate the economy, President Bush proposed a tax cut, while the Fed had been increasing U.S. money supply. Compare the effects of these two policies in terms of their implications for the current account. If policy makers are concerned about the current account deficit, discuss whether stimulatory fiscal policy or monetary policy makes more sense in this case. Then, reconsider similar issues for 2009–10, when the economy was in a deep slump, the Fed had taken interest rates to zero, and the Obama administration was arguing for larger fiscal stimulus.
2. Suppose that American firms become more optimistic and decide to increase investment expenditure today in new factories and office space.
   • How will this increase in investment affect output, interest rates, and the current account?
   • Now repeat part (a), assuming that domestic investment is very responsive to the interest rate so that U.S. firms will cancel most of their new investment plans if the interest rate rises. How will this affect the answer you gave previously?
3. 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. Assume the government allows the exchange rate to float and makes no policy response.
   • Foreign output decreases.
   • Investors expect a depreciation of the home currency.
   • The money supply increases.
   • Government spending increases.
4. How would a decrease in the money supply of Paraguay (currency unit is the “guaraní”) affect its own output and its exchange rate with Brazil (currency unit is the “real”). Do you think this policy in Paraguay might also affect output across the border in Brazil? Explain.
5. For each of the following situations, use the IS-LM-FX model to illustrate the effects of the shock and the policy response. Note: Assume the government responds by using monetary policy to stabilize output, unlike question 3, and assume the exchange rate is floating. 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.
   • Foreign output decreases.
   • Investors expect a depreciation of the home currency.
   • The money supply increases.
   • Government spending increases.
6. Repeat the previous question, assuming the central bank responds in order to maintain a fixed exchange rate. In which case or cases will the government response be the same as in the previous question?
7. This question explores IS and FX equilibria in a numerical example.
   • The consumption function is C = 1.5 + 0.75(Y − T). What is the marginal propensity to consume MPC? What is the marginal propensity to save MPS?
   • The trade balance is TB = 5(1 − [1/E]) − 0.25(Y − 8). What is the marginal propensity to consume foreign goods MPCF? What is the marginal propensity to consume home goods MPCH?
   • The investment function is I = 2 − 10i. What is investment when the interest rate i is equal to 0.10 = 10%?
   • Assume government spending is G. Add up the four components of demand and write down the expression for D.
   • Assume forex market equilibrium is given by i = ([1/E] − 1) + 0.10, where the two foreign return terms on the right are expected depreciation and the foreign interest rate. What is the foreign interest rate? What is the expected future exchange rate?
8. [More Difficult] Continuing the last question, solve for the IS curve: obtain an expression for Y in terms of i, G, and T (eliminate E).
9. Assume that initially the IS curve is given by

   IS₁: Y = ¹² − 1.5T − 30i + 2G

   and that the price level P is 1, and the LM curve is given by

   LM₁: M = Y(1 − i)

   The home central bank uses the interest rate as its policy instrument. Initially, the home interest rate equals the foreign interest rate of 10% or 0.1. Taxes and government spending both equal 2. Call this case 1.

   • According to the IS₁ curve, what is the level of output Y? Assume this is the desired full-employment level of output.
   • According to the LM₁ curve, at this level of output, what is the level of the home money supply?
   • Plot the IS₁ and LM₁ curves for case 1 on a chart. Label the axes, and the equilibrium values.
   • Assume that forex market equilibrium is given by i = ([1/E] − 1) + 0.10, where the two foreign return terms on the right are expected depreciation and the foreign interest rate. The expected future exchange rate is 1. What is today’s spot exchange rate?
   • There is now a foreign demand shock, such that the IS curve shifts left by 1.5 units at all levels of the interest rate, and the new IS curve is given by
     IS₂: Y = 10.5 − 1.5T − 30i + 2G
     The government asks the central bank to stabilize the economy at full employment. To stabilize and return output back to the desired level, according to this new IS curve, by how much must the interest rate be lowered from its initial level of 0.1? (Assume taxes and government spending remain at 2.) Call this case 2.
   • At the new lower interest rate and at full employment, on the new LM curve (LM₂), what is the new level of the money supply?
   • According to the forex market equilibrium, what is the new level of the spot exchange rate? How large is the depreciation of the home currency?
   • Plot the new IS₂ and LM₂ curves for case 2 on a chart. Label the axes, and the equilibrium values.
   • Return to part (e). Now assume that the central bank refuses to change the interest rate from 10%. In this case, what is the new level of output? What is the money supply? And if the government decides to use fiscal policy instead to stabilize output, then according to the new IS curve, by how much must government spending be increased to achieve this goal? Call this case 3.
   • Plot the new IS₃ and LM₃ curves for case 3 on a chart. Label the axes, and the equilibrium values.
10. In this chapter, we’ve studied how policy responses affect economic variables in an open economy. Consider each of the problems in policy design and implementation discussed in this chapter. Compare and contrast each problem as it applies to monetary policy stabilization versus fiscal policy stabilization.