Chapter 10

Numerical Problems
1. The price level in the West is Pw = 5 guilders per ordinary soap bar. The price level
in the East is PE = 100 florins per deluxe soap bar. The real exchange rate is 2
ordinary soap bars per deluxe soap bar.
a. Use the formula enom = ePFor/P = 2 ordinary soap bars per deluxe soap bar x 5
guilders per ordinary soap bar / 100 florins per deluxe soap bar = 0.10 guilders
per florin, or 10 florins per guilder.
b. Inflation in the West is w = 10%. Inflation in the East is e = 20%. The real
exchange rate is constant. Use Eq. (10.3) to get enom/enom = (e/e) + For =
0. So the nominal exchange rate (guilders per florin) depreciates at a 10% rate.
The East Bubble florin depreciates, the West Bubble guilder appreciates.
2. a. The financial market expected the exchange rate to appreciate.
b. The financial market expected the exchange rate to be 0.71159 in 3 months.
c. She would have realized a rate of return equal to 4.116%.
3. Begin by writing the equation for the IS curve, which is Sd Id = NX.
Sd = Y Cd G = Y (300 0.5Y 200r) G.
NX = 150 0.1Y 0.5e = 150 0.1Y 0.5(20 600r) = 140 0.1Y 300r.
Using these in the IS curve equation gives:
(0.5Y 300 200r G) (200 300r) = 140 0.1Y 300r.
Rearranging terms and simplifying gives the IS curve:
800r = 640 0.6Y G.
a. With G = 100 and = 900, the IS curve gives 800r = 640 540 100 = 200, so
r = .25. Then e = 20 600r = 170, NX = 150 90 85 = 25, C = 300 + 450
50 = 700, and I = 200 75 = 125.
b. With = 940, the IS curve gives 800r = 640 564 + 100 = 176, so r = .22.
Then e = 20 + 600r = 152, NX = 150 94 76 = 20, C = 300 + 470 44 =
726, and / = 200 66 = 134. The rise in domestic output reduces the real
interest rate and real exchange rate, and increases net exports, consumption,
and investment.
c. With G = 132, the IS curve gives 800r = 640 564 + 132 = 208, so r = .26.
Then e = 20 + 600r = 176, NX = 150 94 88 = 32, C = 300 + 470 52 =
718, and / = 200 78 = 122. The rise in government spending increases the
real interest rate and the real exchange rate, and decreases net exports,
consumption, and investment.
4. Begin by writing the equation for the IS curve, which is Sd /d = NX.
Sd = Y Cd G = Y {200 + 0.6[Y (20 + 0.2Y)] 200r} G = 0.52Y (188 + G)
+ 200r
Using these in the IS curve equation gives:
0.52Y (188 + G) + 200r (300 300r) = 150 0.08Y 500r.
Rearranging terms and simplifying gives the IS curve:

171

Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy

172

1000r = (638 + G) 0.6Y

The LM curve comes from the expression M/P = L, which is 924/P = 0.5Y 200r.
In the long run we'll use this equation to find the price level, so we'll write this as P
= 924/(0.5Y 200r). In the short run we'll combine the LM curve with the IS curve
to find equilibrium, so we'll write it as 200r = 0.5Y 924/P.
a. With G = 152 and = 1000, the IS curve gives 1000r = 790 600 = 190. so r =
0.19
From the LM curve, P = 924/(500 38) = 2. Then NX = 150 80 95 = 25, C
= 200 0.6(1000 220) 38 = 630, and / = 300 57 = 243.
b. In the short run with G = 212 and P = 2, the IS curve gives 1000r = (638 + 212)
0.6Y, and the LM curve is 200r = 0.5Y 462. Take five times the LM equation
and subtract it from the IS equation to get (850 + 2310) 3.1Y = 0, or Y =
1019.36. Plug this in the LM equation to get r = 0.24. Then NX = 150 81.55
120 = 51.55, C = 200 + 0.6(1019.36 224) 48 = 629.29, and / = 300 72 =
228.
In the long run, using Y = 1000 in the IS curve gives 1000r = (638 + 212) (0.6
1000)
= 250, so r = 0.25. Then NX = 150 80 126 = 56. C = 200 +
468 50 = 618, and I = 300 75 = 225.
c. The nominal money supply remains at 924. Then the LM curve implies, P =
924/(500 50) = 2.05. It then follows that the real money supply is 450. Thus,
in the long-run, the price level will go up and the real money supply will go
down.
5.

a. r = 0.175 (17.5%). Using either IS or LM, the value of r at

= 300.

b. Domestic output falls to Y = 175. With fixed price level and fixed exchange rate,
short run equilibrium occurs on IS at r = 0.225. Using the equation of LM, if Y =
175 and r = 0.225, then M = 42.5.
c. Domestic output increases to Y = 320. With a fixed price level and flexible
exchange rate, short run equilibrium occurs on LM at r = 0.225. Using the
equation of IS, if Y = 320 and r = 0.225, then e = 32.
d. In the long run, the price level increases if the exchange rate is flexible but
decreases if it is fixed.

Analytical Problems
1.

a. Import restrictions cause net exports to increase. The IS curve, then, shifts to
the right. The result is a temporary increase in the domestic interest rate above
the foreign interest rate. This presents arbitrage opportunities which cause a
capital inflow into the domestic economy. As a result, the domestic currency
appreciates and this causes net exports to fall. The fall in net exports causes
the domestic interest rate to fall until it is again equal to the foreign interest rate.
The IS curve has returned to its original position. In equilibrium, there has been

Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy

173

no change in output, no change in the interest rate, and no change in net

exports. The real exchange rate has appreciated, exports have fallen and
imports have increased.
b. The answer to part (a) is not affected if the domestic price level is allowed to
adjust. The reason is that unless we believe the exchange rate responds only
very slowly to the temporary increase in the domestic interest rate, there is no
reason to believe there is a change in output. As a consequence, there is no
change in the price level.
c. Import restrictions cause net exports to increase. The IS curve shifts to the
right. The result is a temporary increase in the domestic interest rate above the
foreign level. If the exchange rate is fixed, the resulting capital inflow creates an
undervalued exchange rate. The solution to an undervalued exchange rate is
for the domestic central bank to increase the domestic money supply. The LM
curve shifts to the right until the domestic interest rate is equal to the foreign
interest rate. This halts the capital inflow and keeps the value of the exchange
rate constant. Domestic output has increased, the real exchange rate is not
affected, exports are not affected, imports have been reduced, and net exports
have increased.
d. The fact that output has increased means that the domestic price level
increases. As a consequence, the real exchange rate increases. This causes
net exports to fall (exports fall and imports rise) and the IS curve shifts back to
the left. The domestic money supply must be reduced in order to prevent an
over or undervaluation of the currency. In the end, both IS and LM have
returned to their original positions. When we allow the price level to adjust, the
import restriction ends up having no effect on output. The real exchange rate
has increased due to the increase in the domestic price level. Net exports are
unaffected, however. Exports have been reduced and imports have increased
by equal amounts.
2.

a. The actions of legislators in Country B cause Country A exports to fall. A fall in

net exports shifts IS to the left causing a temporary fall in the domestic interest
rate below the foreign interest rate. The result is a capital outflow from Country
A and an exchange rate depreciation. The depreciation causes exports to
increase, imports to decrease, and net exports to increase. The IS curve
returns to its original position. In the end, there is no change in output, no
change in net exports, imports have been reduced, and exports have been
increased.
b. Assuming a relatively speedy response of the exchange rate to the change in
the domestic interest rate, allowing the price level to change has no impact on
the solution to part (a).

Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy

174

c. The fall in exports caused by foreign legislation causes IS to shift to the left.
The result is an overvalued exchange rate. The solution to an overvalued
exchange rate is for the domestic central bank to decrease the domestic money
supply. The LM curve shifts to the left until the domestic interest rate is equal to
the foreign interest rate. This halts the capital outflow and keeps the value of
the exchange rate constant. Domestic output has fallen, the real exchange rate
is not affected, net exports have fallen, exports have fallen, and imports have
fallen.
d. Since output has fallen, the domestic price level falls. This causes the real
exchange rate to fall which in turn causes exports to increase, imports to
decrease and net exports to increase. The IS curve shifts back to the right as
does the LM curve (so as to prevent any over or undervaluation of the
currency). In the end we return to the original equilibrium that was observed
prior to the foreign legislation. Output is unaffected, net exports are unaffected,
exports have fallen and imports have fallen.

3.

a. The monetary expansion in Country Y causes the world interest

rate to decrease. The implication is that the domestic interest rate in Country X
is above the world interest rate. Country X realizes a capital inflow that
produces a currency appreciation. Net exports decrease causing IS to shift to
the left until the domestic interest rate falls sufficiently to equal the world
interest rate. Country X output decreases, net exports decrease, and the
interest rate decreases.

b. The fiscal expansion in Country Y causes the world interest rate to increase.
The implication is that the domestic interest rate in Country X is below the new,
higher, world interest rate. Country X realizes a capital outflow that produces a
currency depreciation. Net exports increase causing IS to shift to the right until
the domestic interest rate increases to equal the world interest rate. Country X
output increases, net exports increase, and the interest rate increases.
4.

An increase in full employment output shifts the FE line to the right. In the short
run, there is no other change. In the long run, the economy is below the full
employment level of output and hence the price level falls. The causes the real
exchange rate to fall. The currency depreciation causes net exports to increase
shifting the IS curve to the right. At the same time, the fall in the price level causes
the LM curve to shift to the right. IS and LM interest at the new higher level of full
employment output and at the foreign interest rate. Output increases, the price
levels falls, the real exchange rate falls, net exports increase.