# International Monetary Economics Tutorial

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University of Konstanz - Chair of Monetary Economics

International Monetary Economics Tutorial
Winter Term 2004/05

Problem Set 3

Exercise 3.1 (S)
J-curve
You observe that a country’s currency depreciates but its current account
worsens at the same time.
a) What data might you look at to decide whether you are witnessing a
J-curve eﬀect?

b) What other macroeconomic change might bring about a currency de-
preciation coupled with a deterioration of the current account, even if
there is no J-curve?

Exercise 3.2 (T)
Mundell-Fleming-Model – Comparative Statics - Formal Analysis
a) Flexible exchange rate Assume following formulation of the MFM
with ﬂexible exchange rate:

IS)      Y = C(Y ) + I(i) + G + N X(Y, S, Y ∗ )         (1)
LM )      M = L(i, Y )                                   (2)
∗           ∗
F E)     N X(Y, S, Y ) + K(i − i ) = 0                  (3)

a.1) Distinguish between exogenous and endogenous variables, thereby
remember that we assume ﬂexible exchange rates.
a.2) Analyze the eﬀect of a Monetary expansion analytically, through
comparative statics.
a.3) Analyze the eﬀect of a Fiscal expansion analytically, through com-
parative statics.

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b) Fixed exchange rate Assume following formulation of the MFM with
ﬁxed exchange rate:

IS)      Y = C(Y ) + I(i) + G + N X(Y, S, Y ∗ )        (4)
LM )      M = φ(D + R) = L(i, Y )                       (5)
∗            ∗
F E)     N X(Y, S, Y ) + K(i − i ) = 0                 (6)

where φ is the money multiplier, D is domestic credit and R are the
foreign reserves.

a.1) Distinguish between exogenous and endogenous variables, thereby
remember that we assume ﬁxed exchange rates.
a.2) Analyze the eﬀect of a Monetary expansion analytically, through
comparative statics.
a.3) Analyze the eﬀect of a Fiscal expansion analytically, through com-
parative statics.

Exercise 3.3 (B)
Mundell-Fleming Model
Discuss the following statements and questions:

a) Under perfect capital mobility the MFM implies that monetary policy
has no eﬀect on exchange rates.

b) Fiscal policy has no eﬀect on output under the MFM.

c) How does policymaking in an open economy depend on the degree of
capital mobility?

d) How does policymaking in an open economy depend on the formation
of exchange rate expectations?

e) How does policymaking in an open economy depend on wealth eﬀects?

f) How does policymaking in an open economy depend on the ﬂexibility
of prices?

Exercise 3.4 (S)
Mundell-Fleming Model – Shocks
Use the Mundell-Fleming model to predict what would happen to aggregate
income, the exchange rate and the trade balance under both ﬂoating and
ﬁxed exchange rates in response to each of the following shocks:

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a) A fall in consumer conﬁdence about the future induces consumers to
spend less and save more.

b) The introduction of a stylish line of Toyotas makes some consumers
prefer foreign cars over domestic cars.

c) The introduction of automatic teller machines reduces the demand for
money.

d) Due to an ageing society, world saving reduces. This leads to an in-
crease in the world interest.

Exercise 3.5 (S)
Suppose that money demand depends on disposable income, so that the
equation for the money market becomes:

M/P = L(i, Y − T ).

Analyze the impact of a tax cut in a small open economy on the exchange
rate and income under both ﬂoating and ﬁxed exchange rates.

Exercise 3.6 (S)
Suppose that the price level relevant for money demand is the consumer price
index which includes the price of imported goods. Furthermore, the price of
imported goods depends on the exchange rate.
That is, the money market is described by:
M
= L(i, Y )
Pc
where Pc = λP + (1 − λ)PM S. The parameter λ is the share of domestic
goods in the consumer price index Pc . Assume that the price of domestic
goods P and the price of foreign goods measured in foreign currency PM are
ﬁxed.

a) Suppose we graph the LL curve for given values of P and PM . Explain
why in this model the LL curve is upward sloping rather than vertical.

b) What is the eﬀect of expansionary ﬁscal policy under ﬂoating exchange
rates in this model? Explain. Contrast with the standard Mundell-
Fleming model.

c) Suppose that political instability increases the country risk premium
and, thereby, the interest rate. What is the eﬀect on the exchange rate,
the price level, and aggregate income in this model? Contrast with the
standard Mundell-Fleming model.

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