Particular attention will be paid to the role of government policy on macroeconomic equilibrium for an open and closed economy

The foreign exchange market involves firms, households, and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers. Figure 1 (a) offers an example for the exchange rate between the U.S. dollar and the Mexican peso. The vertical axis shows the exchange rate for U.S. dollars, which in this case is measured in pesos. The horizontal axis shows the quantity of U.S. dollars being traded in the foreign exchange market each day. The demand curve (D) for U.S. dollars intersects with the supply curve (S) of U.S. dollars at the equilibrium point (E), which is an exchange rate of 10 pesos per dollar and a total volume of $8.5 billion.

The left graph shows the supply and demand for exchanging U.S. dollars for pesos. The right graph shows the supply and demand for exchanging pesos to U.S. dollars.
Figure 1. Demand and Supply for the U.S. Dollar and Mexican Peso Exchange Rate. (a) The quantity measured on the horizontal axis is in U.S. dollars, and the exchange rate on the vertical axis is the price of U.S. dollars measured in Mexican pesos. (b) The quantity measured on the horizontal axis is in Mexican pesos, while the price on the vertical axis is the price of pesos measured in U.S. dollars. In both graphs, the equilibrium exchange rate occurs at point E, at the intersection of the demand curve (D) and the supply curve (S).

Figure 1 (b) presents the same demand and supply information from the perspective of the Mexican peso. The vertical axis shows the exchange rate for Mexican pesos, which is measured in U.S. dollars. The horizontal axis shows the quantity of Mexican pesos traded in the foreign exchange market. The demand curve (D) for Mexican pesos intersects with the supply curve (S) of Mexican pesos at the equilibrium point (E), which is an exchange rate of 10 cents in U.S. currency for each Mexican peso and a total volume of 85 billion pesos. Note that the two exchange rates are inverses: 10 pesos per dollar is the same as 10 cents per peso (or $0.10 per peso). In the actual foreign exchange market, almost all of the trading for Mexican pesos is done for U.S. dollars. What factors would cause the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? The answer to this question is discussed in the following section.

Question Description

This course examines further issues on the determination of the equilibrium level of national income and its allocation among consumers, investors and government. Particular attention will be paid to the role of government policy on macroeconomic equilibrium for an open and closed economy. Additional issues to be discussed include government debt and deficit, investment, money demand and money supply, unemployment, economic fluctuations, and growth. We will also discuss business cycles: recessions, depressions, revivals, expansions.

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Professor Chauvet Econ 105B – Problem Set 5 QUESTIONS FOR REVIEW 1. In the Mundell–Fleming model with fixed exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when taxes are raised. 2. In the Mundell–Fleming model with fixed exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when the money supply is reduced. 3. In the Mundell–Fleming model with fixed exchange rates, explain what happens to aggregate income, the exchange rate, and the trade balance when a quota on imported cars is removed. 4. What are the advantages and disadvantages of floating exchange rates and fixed exchange rates? 5. Describe the impossible trinity. .PROBLEMS AND APPLICATIONS Problems and Applications: 2, 4, 5 2. A small open economy is described by the following equations: C = 50+0.75 (Y−T) I = 200−20r NX = 200−50ε M/P = Y−40r G = 200 T = 200 M = 3,000 P=3 r∗ = 5 Use the equilibrium exchange rate, income, and net exports you calculated in problem set 4. Assume a fixed exchange rate. Calculate what happens to the exchange rate, income, net exports, and the money supply if the government increases its spending by 50. Use a graph to explain what you find. 4. The Mundell–Fleming model takes the world interest rate r∗ as an exogenous variable. Let’s consider what happens when this variable changes. a. If the economy has a fixed exchange rate, what happens to aggregate income, the exchange rate, and the trade balance when the world interest rate rises? 1 Professor Chauvet Econ 105B – Problem Set 5 9. Use the Mundell–Fleming model to answer the following questions about the state of California (a small open economy). a. What kind of exchange-rate system does California have with its major trading partners (Alabama, Alaska, Arizona, . . .)? b. If California suffers from a recession, should the state government use monetary or fiscal policy to stimulate employment? Explain. (Note: For this question, assume that the state government can print dollar bills.) c. If California prohibited the import of wines from the state of Washington, what would happen to income, the exchange rate, and the trade balance? Consider both the short-run and the long-run impacts. d. Can you think of any important features of the Californian economy that are different from, say, the Canadian economy, making the Mundell–Fleming model less useful when applied to California than to Canada? Questions from Appendix – LOE in the SR 1. Imagine that you run the central bank in a large open economy with a floating exchange rate. Your goal is to stabilize income, and you adjust the money supply accordingly. Under your policy, what happens to the money supply, the interest rate, the exchange rate, and the trade balance in response to each of the following shocks? a. The government raises taxes to reduce the budget deficit. b. The government restricts the import of foreign cars. 3. Suppose policymakers in a large open economy want to raise investment without changing income or the exchange rate: a. Is there any combination of domestic monetary and fiscal policies that would achieve this goal? b. Is there any combination of domestic monetary, fiscal, and trade policies that would achieve this goal? c. Is there any combination of monetary and fiscal policies at home and abroad that would achieve this goal? 4. This appendix considers the case of a large open economy with a floating exchange rate. Now suppose that a large open economy has a fixed exchange rate. That is, the central bank announces a target for the exchange rate and commits itself to adjusting the money supply to ensure that the equilibrium exchange rate equals the target. a. Describe what happens to income, the interest rate, and the trade balance in response to a fiscal expansion, such as an increase in government purchases. Compare your answer to the case of a small open economy with a fixed exchange rate. 2 Professor Chauvet Econ 105B – Problem Set 5 b. Describe what happens to income, the interest rate, and the trade balance if the central bank expands the money supply by buying bonds from the public. Compare your answer to the case of a small open economy with a fixed exchange rate. 3 …

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