Homework 4-
1. Use the Mundell-Fleming Model of a small open economy under a floating exchange rate regime to answer this question. Suppose the initial equilibrium for this economy in shown in the graph below:
a. Suppose there is an increase in taxes in this economy. Redraw the above graph showing the effects of this policy change on the IS* curve, the LM* curve, the level of output and the exchange rate.
b. Given your answer in part (a), what happens to the trade balance? Explain your answer.
c. Suppose instead of a change in fiscal policy the central bank of this economy increases the money supply.
i. What is the effect of this change in the money supply on real balances?
ii. What is the effect of this change in the money supply on the LM* curve, the exchange rate, and the level of aggregate output?
iii. What is the effect of an increase in the money supply on the trade balance? Explain your answer.
d. When is monetary policy effective according to the Mundell-Fleming Model?
2. Use the sticky wage model to answer this set of questions.
a. Suppose the nominal wage does not change, but the aggregate price level increases. Explain what happens to the real wage, employment, and aggregate output.
b. Suppose the nominal wage increases by a smaller percentage than the rate of inflation in an economy. Explain what happens to the real wage, employment, and aggregate output.
3. Use the AD-AS Model to answer the following question. Assume the model is initially in long-run equilibrium and that the economy is a closed economy. Assume the short-run price level is sticky but not fixed at a constant level.
a. Suppose there is a positive demand shock. Describe verbally and with a graph the short-run effects of this demand shock.
b. Redraw your graph from part (a) but, this time in your graph include the long-run adjustment to this positive demand shock. Explain your graph.
c. Suppose the central bank decreases the money supply. Describe verbally and with a graph the short-run effects of this policy.
d. Redraw your graph from part (c) but, this time in your graph include the long-run adjustment to this monetary policy.
e. Why is a negative supply shock a challenge to policy makers? Use a graph to illustrate your answer.