International Monetary Economics Tutorial

							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.

  c) Summarize your results.

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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