## PROBLEMS AND APPLICATIONS

415

1. Use the Mundell–Fleming model to predict what would happen to aggregate income, the exchange rate, and the trade balance under both floating and fixed exchange rates in response to each of the following shocks:

1. A fall in consumer confidence about the future induces consumers to spend less and save more.

2. The introduction of a stylish line of Volkswagens makes some consumers prefer foreign cars over domestic cars.

3. The introduction of automatic teller machines reduces the demand for money.

2. A small open economy with a floating exchange rate is in recession with balanced trade. If policymakers want to reach full employment while maintaining balanced trade, what combination of monetary and fiscal policy should they choose?

3. The Mundell–Fleming model takes the world interest rate r* as an exogenous variable. Let’s consider what happens when this variable changes.

1. What might cause the world interest rate to rise?

2. In the Mundell–Fleming model with a floating exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises?

3. In the Mundell–Fleming model with a fixed exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises?

4. Business executives and policymakers are often concerned about the “competitiveness” of Canadian industry (the ability of Canadian industries to sell their goods profitably in world markets).

1. How would a change in the nominal exchange rate affect competitiveness in the short-run when prices are sticky?

2. Suppose you wanted to make domestic industries more competitive but did not want to alter aggregate income. According to the Mundell–Fleming model, what combination of monetary and fiscal policies should you pursue?

5. Suppose that higher income implies higher imports and thus lower net exports. That is, the net exports function is

NX = NX(e, Y).

Examine the effects in a small open economy of a fiscal expansion on income and the trade balance under

1. A floating exchange rate.

2. A fixed exchange rate.

6. Suppose that money demand depends on disposable income, so that the equation for the money market becomes

M/P = L(r, YT).

Analyze the impact of a tax cut in a small open economy on the exchange rate and income under both floating and fixed exchange rates.

7. Suppose that the price level relevant for money demand includes the price of imported goods and that the price of imported goods depends on the exchange rate. That is, the money market is described by

M/P = L(r, Y),

where

P = λPd + (1 – λ)Pf/e.

The parameter λ is the share of domestic goods in the price index P. Assume that the price of domestic goods Pd and the price of foreign goods measured in foreign currency Pf are fixed.

1. Suppose we graph the LM* curve for given values of Pd and Pf (instead of the usual P). Is this LM* curve still vertical? Explain.

2. What is the effect of expansionary fiscal policy under floating exchange rates in this model? Explain. Contrast with the standard Mundell–Fleming model.

3. Suppose that political instability increases the country risk premium and, thereby, the interest rate. What is the effect on the exchange rate, the price level, and aggregate income in this model? Contrast with the standard Mundell–Fleming model. This question anticipates part of what is covered in the appendix of this chapter.

416

8. Use the Mundell–Fleming model to answer the following questions about the province of Alberta (a small open economy).

1. What kind of exchange-rate system does Alberta have with its major trading partners (the provinces of British Columbia and Ontario)?

2. If Alberta suffers from a recession, should the provincial government use monetary or fiscal policy to stimulate employment? Explain. (Note: For this question, assume that the provincial government can print dollar bills.)

3. If Alberta prohibited the import of wines from the province of Ontario, what would happen to income, the exchange rate, and the trade balance? Consider both the short-run and the long-run impacts.