Q. Exercise 1
Graphically represent on the IS/LM/FX diagram the effects of the following cases; use a new diagram for each case and do not forget to label the axes and the curves. Start from an initial equilibrium point 0 and clearly show which curve(s) would shift. Label the intermediate equilibrium points sequentially 1, 2, etc. until the ...final equilibrium is reached.
1. The Federal Reserve implements an expansionary monetary policy. Exchange rate is flexible.
2. The expected exchange rate falls. Exchange rate is ‡flexible.
3. The expected exchange rate falls. Exchange rate has to be kept ...fixed now.
4. Government spending G is reduced. Exchange rate is ...fixed.
5. The government implements a tax cut. Exchange rate is ‡flexible.
Exercise 2
Represent graphically the effects of an expansionary monetary policy and a contraction fiscal policy in the IS/LM/FX model. Describe how the open economy channel interacts with the implementation of the policy and explain the differences between the open and closed economy versions of the model in terms of policy outcomes. In particular, say whether the change in income is larger in open economy or in closed economy. Be as specific as possible in describing and representing the effects of each policy.
Exercise 3
What would you do in each of the following scenarios? Use the IS/LM/FX representation.
1. The liquidity preference of people increase. What should the Central Bank do to keep the real exchange rate peg?
2. The central bank thinks that the exchange rate is over-appreciated.
3. A negative shock to the demand of goods makes the output fall. The government wants to close the recessionary gap.
4. A negative shock to the demand of goods makes the output fall but the central bank has to keep the exchange rate peg.
5. The Government implements an expansionary fiscal policy, but the exchange rate is fixed. How does the Central Bank respond to reestablish the peg?