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ECN 410

Fall 2021

Exam II

1. Use the DD-AA (Augmented Open Economy IS-LM) Model to answer the following about the impact of short-run shocks on Y and e. Approach parts a) and b) independently from the perspective of the domestic economy. Show the market where the shock originates as well as the overall market of aggregate demand.

a) An increase in consumer confidence increases private consumption levels.

b) Suppose the Biden Administration raises corporate tax rates. 

c) How does the increase in taxes from part b) impact value of the dollar? How would this change in e ultimately impact the competitiveness of domestic exporters in global markets?

d) Will this change in competitiveness manifest in the immediate short-term? Use the value and volume effects to explain.

2. Suppose the Federal Reserve responds to increasing inflation concerns by raising interest rates to curb aggregate

demand within the US.

a) How does the Federal Reserve raise interest rates in practice? How does this impact domestic aggregate demand? Illustrate and explain the impact on US Y and the value of the dollar relative to the Saudi riyal. (No need to show the simultaneous equilibrium model, simply use the overall market of aggregate demand).

b) In a global economy, the impact of US policy extends beyond US borders. Show the impact of the US policy from part a) on aggregate demand within Saudi Arabia. What is the impact on income, the rate of return and the value of the Saudi riyal? Do we know for certain whether the riyal will appreciate or depreciate relative to the dollar? How do you know?

c) Now assume that Saudi Arabia fixes the riyal to the value of the dollar to maintain stability in light of being reliant on oil exports. How would fixing the riyal/dollar exchange rate impact the outcome from part b)? Show how the Saudi central bank would respond.

3. The Biden Administration recently implemented a large-scale infrastructure expenditure package.

a) Illustrate and explain the impact of such a policy in the domestic Goods market. How does the change in income in the Goods market compare to the ultimate injection of expenditure by the government? How do you know?

b) How does this spending package impact the overall market for aggregate demand? How does the value of the dollar respond? How does the final change in Y compare to the change in the Goods market? How do you know?

4. Europe as an Optimal Currency Area

a) What is the main cost associated with a large open economy such as Spain adopting the euro and joining a currency union?

b) Suppose there is a region-specific negative shock in Spain. How would wages in Spain move relative to wages in Germany (who did not experience the negative shock)?

c) What characteristic is necessary to offset the divergence of wages in due to part b) and maintain the Eurozone as an optimal currency area? (There are multiple correct answers here, you just need to give one).