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ECN 410

Fall 2020

Take-Home Midterm II

Due via email Saturday 12/5 by 11:59p EST

1. Use the DD-AA (Augmented Open Economy IS-LM) Model to answer the following about short-run policy impacts on Y and e. Approach each question independently from the perspective of the US:

a) Suppose in response to this global recession, the United States decides to remove tariffs previously levied on Canadian goods. Be sure to illustrate the policy’s impact in the underlying market (either the goods or asset market) as well as the overall AD market within the US.

b) Now suppose in response to our current recession, the US government passes an infrastructure spending package. What effects does this have on equilibrium in the goods market as well as the overall DD-AA market? How does the ultimate change in Y compare to the initial injection of government expenditure? How do you know?

c) Suppose instead, the Canadian government enacts a large-scale stimulus package while the US does not. Show how this external shock will impact income in the US and the $/CAD exchange rate.

2. Fixed Exchange Rates Systems

 a) What is the main cost associated with fixing your exchange rate?

b) Denmark is not a member of the Eurozone, but they have a fixed exchange rate system where their currency, the krone, is pegged to the euro. Suppose the European Central Bank enacts a large-scale expansion of the supply of euros. What does this do to the relative value of krone? How can Denmark offset this action to maintain a fixed e? Would this sterilization require open market purchases or sales?

c) If this relative movement of the euro with respect to the krone is prolonged, could this present a problem to the viability of the krone’s current peg? Why or why not?

3. Optimal Currency Areas

a) What is the main cost associated with adopting a common currency? What characteristic of potential member states is necessary to reduce this potential cost?

b) As of June 2020, Portugal had a debt-to-GDP ratio of roughly 130%. Suppose Covid-19, and consequently this recession, has hit Portugal more severely than the rest of the Eurozone. What policy responses can they individually implement to restore internal balance?

c) Does the pursuit of internal balance in part b) also move Portugal towards external balance? Why or why not?