Intermediate
Macroeconomics
Tutorial 2
Chapter 2 & 4: The Open Economy
- IS-LM-BP Model
- Monetary and Fiscal Policy Under Flexible Exchange Rates
,T2 2.1, 2.2, 4.6
2.1 Short Ques.ons
Fixed exchange rates – perfect immobile capital.
If financial capital is completely immobile interna3onally and the economy operates under a system of
fixed exchange rates, then a bond financed increase in government consump3on will lead to an
increase in the interest rate and crowding out of investment.
The IS-curve shi.s outwards due to the government injec8on and output increases. The BoP is in deficit
because it nega8vely depends on output. The current account is in deficit indicates that imports exceed
exports. Hence, there is an excess demand for foreign exchange.
To keep the exchange rate stable the central bank must intervene and sells its foreign exchange
(∆𝑁𝐹𝐴 ↓) in turn for domes8c currency which are thus taken out of circula8on. Therefore, The money
supply declines as foreign reserves are lost in the maintenance of the exchange rate. The LM curve
shi.s up (le.) and the interest rate increases. In the long-run there is no effect on output and lower
investment as the interest rates are higher. The government interven8on results in no change in output
and crowding-out of investment.
1
, T2 2.1, 2.2, 4.6
In the standard open-economy model we assume that net exports are a func3on of the real exchange
rate, 𝑄 = 𝐸𝑃∗ /𝑃, where 𝐸 is the nominal exchange rate, 𝑃∗ is the foreign price level, and 𝑃 is the
domes3c price level. Then “in the absence of transporta3on costs the real exchange rate is always equal
to unity IF domes3c and foreign goods were perfect subs3tutes for each other”
The Law of One Price (LOP) would hold in that case, meaning that 𝑃 = 𝐸𝑃∗ always. But the standard
open-economy model assumes that these goods are imperfect subs8tutes. This explains why the LOP
does not hold. The Armington approach explains how imperfect subs8tutability is captured in the
model.
2
Macroeconomics
Tutorial 2
Chapter 2 & 4: The Open Economy
- IS-LM-BP Model
- Monetary and Fiscal Policy Under Flexible Exchange Rates
,T2 2.1, 2.2, 4.6
2.1 Short Ques.ons
Fixed exchange rates – perfect immobile capital.
If financial capital is completely immobile interna3onally and the economy operates under a system of
fixed exchange rates, then a bond financed increase in government consump3on will lead to an
increase in the interest rate and crowding out of investment.
The IS-curve shi.s outwards due to the government injec8on and output increases. The BoP is in deficit
because it nega8vely depends on output. The current account is in deficit indicates that imports exceed
exports. Hence, there is an excess demand for foreign exchange.
To keep the exchange rate stable the central bank must intervene and sells its foreign exchange
(∆𝑁𝐹𝐴 ↓) in turn for domes8c currency which are thus taken out of circula8on. Therefore, The money
supply declines as foreign reserves are lost in the maintenance of the exchange rate. The LM curve
shi.s up (le.) and the interest rate increases. In the long-run there is no effect on output and lower
investment as the interest rates are higher. The government interven8on results in no change in output
and crowding-out of investment.
1
, T2 2.1, 2.2, 4.6
In the standard open-economy model we assume that net exports are a func3on of the real exchange
rate, 𝑄 = 𝐸𝑃∗ /𝑃, where 𝐸 is the nominal exchange rate, 𝑃∗ is the foreign price level, and 𝑃 is the
domes3c price level. Then “in the absence of transporta3on costs the real exchange rate is always equal
to unity IF domes3c and foreign goods were perfect subs3tutes for each other”
The Law of One Price (LOP) would hold in that case, meaning that 𝑃 = 𝐸𝑃∗ always. But the standard
open-economy model assumes that these goods are imperfect subs8tutes. This explains why the LOP
does not hold. The Armington approach explains how imperfect subs8tutability is captured in the
model.
2
