41-374: International Economics II
Assignment 3
Part I. Chapter 5
1. Use the following information on a hypothetical economy, Rijkdom, for the year 2006.
Balance of Payments Accounts National Income and Product Accounts
Current account surplus of $1 billion GNE is $8 billion ($8,000 million)
Nonreserve financial account deficit of $850 million Consumption is $5 billion ($5,000 million)
Capital account surplus of $75 million Government purchases total $1.1 billion
Foreign factors located in Rijkdom earn $150 million A $250 million government budget deficit
Trade surplus of $700 million
Net of -$50 million in unilateral transfers
A. Calculate Rijkdoms financial account balance. What has happened to Rijkdoms foreign
asset position? Explain in detail in terms of Rijkdomian assets and foreign assets (owned by
Rijkdomians and foreigners).
B. Calculate the official settlements balance (Change in foreign reserve) for Rijkdom. Did the
Central Bank of Rijkdom experience a decrease or an increase in its foreign reserve holdings?
Explain this in terms of the figure you calculated and what the official settlements balance
measures.
C. Calculate net factor income from abroad for Rijkdom. How much did Rijkdomian factors
abroad earn?
D. Is Rijkdom a net lender or a net borrower? Explain how you know.
E. Calculate Rijkdoms GDP, GNI(GNP), and GNDI.
F. Calculate investment for Rijkdom.
G. Calculate Rijkdoms national savings and private savings.
Part III. Chapter 7
1. For each of the following situations, use the IS-LM-FX model to illustrate the effects of the
shock. For each case, state the effect of the shock on the following variables (increase, decrease,
no change, or ambiguous): Y, i, E, C, I,TB. Assume the government allows the exchange rate
to float.
A. Foreign income decreases.
B. Investors expect a depreciation of the home currency.
C. Private consumption increases exogenously..
D. The money demand increases.
1
2. Repeat the previous question, assuming the government responds to maintain a fixed ex-
change rate.
3. This question explores IS and FX equilibria in a numerical example.
A. The consumption function is C = 1.5 + 0.75(Y − T ). What is the marginal propensity to
consume, MPC? What is the marginal propensity to save, MPS?
B. The trade balance is T B = 5(1 − E1 ) − 0.25(Y − 8). What is the marginal propen-
sity to consume foreign goods, M P CF ? What is the marginal propensity to consume home
goods, M P CH ?
C. The investment function is I = 2 − 10i. What is investment when the interest rate i is
equal to 0.10 = 10%?
D. Assume government spending is G. Add up the four components of demand and write
down the expression for D.
E. Assume forex market equilibrium is given by i = ( E1 − 1) + 0.10 where the two foreign return
terms on the right are expected depreciation and the foreign interest rate. What is the foreign
interest rate? What is the expected future exchange rate?
F. Solving for the IS curve, obtain an expression for Y in terms of i, G, and T (eliminate E).
4. Assume that initially the IS curve is given by
IS1 : Y = 12 − 1.5T − 30i + 2G
and that the price level P is 1, and the LM curve is given by
LM1 : M = Y (1 − i)
The home central bank uses the interest rate as its policy instrument. Initially, the home
interest rate equals the foreign interest rate of 10% or 0.1. Taxes and government spending
both equal 2. Call this case 1.
A. According to the IS1 curve, what is the level of output Y? Assume this is the desired full
employment level of output.
B. According to the LM1 curve, at this level of output, what is the level of the home money
supply?
C. Plot the IS1 and LM1 curves for case 1 on a chart. Label the axes and the equilibrium
values.
D. Assume that forex market equilibrium is given by
1
i=( − 1) + 0.10
E
where the two foreign return terms on the right are expected depreciation and the foreign
interest rate. The expected future exchange rate is 1. What is today’s spot exchange rate?
2
E. There is now a foreign demand shock, such that the IS curve shifts left by 1.5 units at all
levels of the interest rate, and the new IS curve is given by
IS2 : Y = 10.5 − 1.5T − 30i + 2G
The government asks the central bank to stabilize the economy at full employment. To stabilize
and return output back to the desired level, according to this new IS curve, by how much must
the interest rate be lowered from its initial level of 0.1? (Assume taxes and government
spending remain at 2.) Call this case 2.
F. At the new lower interest rate and at full employment, on the new LM curve (LM2 ), what
is the new level of the money supply?
G. According to the forex market equilibrium, what is the new level of the spot exchange rate?
How large is the depreciation of the home currency?
H. Plot the new IS2 and LM2 curves for case 2 on a chart. Label the axes, and the equilibrium
values.
I. Return to question E. Now assume that the central bank refuses to change the interest rate
from 10%. In this case, what is the new level of output? What is the money supply? And if
the government decides to use fiscal policy instead to stabilize output, then, according to the
new IS curve, by how much must government spending be increased to achieve this goal? Call
this case 3.
J. Plot the new IS3 and LM3 curves for case 3 on a chart. Label the axes and the equilibrium
values.
