Econ 204 Chapter 20 Answer Key

860 Words4 Pages
Chapter 20 HW Answer Key 2. Consider an open economy with flexible exchange rates. Suppose output is at the natural level, but there is a trade deficit. What is the appropriate fiscal-monetary policy mix? We will take “appropriate” to mean that the policy goal is to keep output at the same level (the “natural” level) but to reduce the trade deficit. To reduce the trade deficit (i.e. increase NX) we need a policy that will reduce imports and increase exports. Consider the policy mix shown in the IS-LM diagram below: expansionary monetary policy and contractionary fiscal policy. If they balance, the output will remain the same. Interest rates, however, will fall. When interest rates fall, the currency will depreciate (because fewer foreign investors will want domestic currency to hold domestic bonds). The depreciation of the currency at the same level of income will lead to an increase in exports and a decrease in imports, reducing the trade deficit. i LM IS’ Yn LM’ IS Y 3. In this chapter, we showed that a monetary expansion in an economy operating under flexible exchange rates leads to an increase in output and a depreciation of the domestic currency. a. How does a monetary expansion (in an economy will flexible exchange rates) affect consumption and investment? An increase in output (Y) leads to an increase in consumption (we model this simply as C = c0 + c1Y). An increase in output and a decrease in interest rates both act to increase investment (the simple model representation of this idea is I = b0 + b1Y - b2i). So a monetary expansion, which increases output and decreases interest rates, will increase both consumption and investment. b. How does a monetary expansion (in an economy will flexible exchange rates) affect net exports? The depreciation of the currency will tend to increase exports. It will also tend to

More about Econ 204 Chapter 20 Answer Key

Open Document