ECO 102: Introduction to Macroeconomics Problem Set #6
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ECO 102: Introduction to Macroeconomics
Problem Set #6
Problem 1: Exchange Rates [20 Points]
Suppose that there are only two countries in the world: Localia (which is us), that uses the “Localios” (LCL) as its currency, and Nearovia (our trading partner), which uses “Nearos” (NER) as its currency. For questions 1-3, assume that this exchange rate between the NER and the LCL is flexible.
Now consider the Supply & Demand market for domestic Localios. Suppose also that the Central Bank cuts interest rates at home in Localia.
1. What would we expect to happen to the exchange rate for LCL as a result of this rate cut? Explain using the Supply and Demand Figure for LCL and explain why any movements of any of the curves occur. [3 points]
2. Would this create a recessionary gap, inflationary gap, or neither in Localia? Explain using your AD-AS Figure for Localia. [3 points]
3. Similarly, what is the effect of the interest rate cut in Localia on the exchange rate for Nearos and on short-term GDP in Nearovia? Explain using both the Supply and Demands figure for NER and the AD-AS figure for Nearovia. [4 points]
Now suppose that Localia did not have a flexible exchange rate, but instead wanted to retain a fixed exchange rate with Nearovia. Suppose also that the Central Bank of Localia has still decreased its interest rates.
4. In this case, what actions must the Central Bank take to maintain this fixed exchange rate? Explain your answer. [3 points]
5. Suppose instead that it was Nearovia trying to maintain this fixed exchange rate. What action must their Central Bank take to maintain this fixed exchange rate. Explain your answer. [3 points]
Finally, suppose that Nearovia is considering whether it should adopt flexible or fixed exchange rates with regards to the LCL and it knows that Localia is going to cut its interest rates in the near future.
6. If the Nearovia government is primarily concerned with maintaining stability in its Real GDP, then would fixed or flexible exchange rates produce the smaller change in its Real GDP? Explain your answer. [4 points]
Problem 2: Stabilization [10 Points]
Suppose that we are in a country Localia, again trading LCL as our currency. We are still trading with Nearovia and their Nearos.
Suppose also that Localia begins at its long-term equilibrium level of Real GDP. Now suppose that Localia experiences an increased in its autonomous desired investment.
7. If Localia was a closed economy, what would we expect to happen to its Real GDP and the price level in the short-run? Explain using the AD-AS figure. [1 point]
8. Suppose instead that Localia is an open economy, that trades both goods and assets with Nearovia, and the LCL-NER exchange rate is a flexible exchange rate. What happens to the short-run Real GDP and price level now? Does this flexible exchange rate have a stabilizing or de-stabilizing effect on Real GDP relative to your answer in Q7? Explain using the AD-AS figure. [4 points]
9. Finally, Suppose instead that the LCL-NER exchange rate is a fixed exchange rate instead, maintained by the Localia Central Bank. Does this fixed exchange rate have a stabilizing or de-stabilizing effect on Real GDP relative to your answers in Q7 or Q8? Explain using the AD-AS figure. [3 points]
10. In the case of this fixed exchange rate, what action does the Central Bank of Localia need to take to maintain the fixed rate in this example? [2 points]
2022-04-07