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Economics 4020 Dr. Alston Spring, 2002 Second Midterm (Gordon, Chaps 4-6, 11, 13, 16) 1. Given a small open economy whose structure is given by the following equations: C = 50 - 10r + .75Yd T = 200 + 0.2Y Ip = 200 - 30r G = 500 X = 600 - 5e H = 200 + 0.1Y Ms/P = 300 h = 0.4 f = 50 We begin with the small economy and the world economy having the same interest rate, r = r f, and we assume that the initial exchange rate = 50. a. What is the equation for NX? b. Given this NX, what is the equation for Ap? c. What is the marginal leakage rate? d. What is the equation for the IS curve (stated in terms of Y = f(r))? e. What is the equation for the IS curve (stated in terms of r = f(Y))? f. What is the equation for the LM curve (stated in terms of Y = f(r)) g. What is the equation for the LM curve (stated in terms of r = f(Y)). h. What is the equation for the equilibrium interest rate? i. What is the value of the equilibrium interest rate, r ? j. What is the equation for the equilibrium level of income? k. What is the value of the equilibrium real output, Y ? 2. In the space below, draw in the IS and LM curves from problem one. Label each axis and curve accurately, including horizontal intercept, slope, and equilibrium values for Y and r. (This is intended to give you a chance to verify your answers.) 8 6 4 2 0 400 800 1,200 1,600 2,000 3. We now allow the small economy's interest rate to diverge temporarily from the world economy's interest rate, but in the long run, the domestic interest rate (r) will return to equal the world's interest rate (rf ). In this problem we'll investigate what happens when fiscal policy is used to attempt to stimulate income and employment in a small open economy with a flexible exchange rate. (In the next, we'll investigate what happens when monetary policy is used, instead.) Suppose that government purchases (G) increases to $730 but the exchange rate initially stays at 50. a. What is the equation for the new IS curve (Use the form Y = f(r))? ALSO DRAW IT IN THE GRAPH ABOVE b. What is the equation for the new (temporary) equilibrium interest rate? c. What is the value of the new (temporary) equilibrium interest rate? d. What is the equation for the new (temporary) equilibrium real output, Y? e. What is the value of the new (temporary) equilibrium real output, Y? f. Find the foreign exchange rate at which the small economy's interest rate again equals the world economy's interest rate. (Hint: Recall that the horizontal intercept of the IS curve is kAo. Then the shift in IS represents an intercept change of k times the change in Ao. Find the change in NXo that would offset this shift. Then find the change in e that would produce this change in NXo.) new e' = ___________ New NXo = __________________ g. Discuss the adjustment mechanism that brought the small open economy interest rate back into equality with the world interest rate after the change in government spending. Was there crowding in or crowding out? If so, what was crowded in or out? 4. Using the initial values of the problem, given in question 1, suppose the money supply is increased by $205. Redraw the initial IS-LM diagram, and then make the required change(s) (e.g., add in new LM and/or IS curves as appropriate) that show(s) the impact of an expansionary monetary policy in the economy we have just been investigating. Use the space below the diagram to explain how the outcome differs from expansionary fiscal policy in this small open economy with flexible exchange rates. Explain the adjustment mechanism. 8 6 4 2 400 800 1,200 1,600 2,000