Macroeconomics Homework Answers

EC 102 — Part II Solutions to the Problem Sets

Javier Ortega July 18, 2010

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Solutions to Problem Set 1: Open Economy

1. Mankiw, Chapter 5, Problem 1. Use the model of the small open economy to predict what would happen to the trade balance, the real exchange rate, and the nominal exchange rate in response to each of the following events. (a) A fall in consumer confidence about the future induces consumers to spend less and save more. An increase in saving shifts the (S — I) schedule to the right, increasing the supply of national currency (pounds) available to be invested abroad. The increased supply of pounds causes the equilibrium real exchange rate to fall from ²1 to ²2 . Because the pound becomes less valuable, domestic goods become less expensive relative to foreign goods, so exports rise and imports fall. This means that the trade balance increases. The nominal exchange rate falls following the movement of the real exchange rate, because prices do not change in response to this shock.

(b) The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars. The introduction of a stylish line of Toyotas that makes some consumers prefer foreign cars over domestic cars has no effect on saving or investment, but it shifts the N (²) schedule inward. The trade balance does not change, but the real exchange rate falls from ²1 to ²2 . Because prices are not affected, the nominal exchange rate follows the real exchange rate.

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(c) The introduction of automatic teller machines that reduces the demand for money. In the model under consideration, the introduction of ATMs has no effect on any real variables. The amounts of capital and labor determine output Y . The world interest rate r∗ determines investment I(r∗ ). The difference between domestic saving and domestic investment (S − I) determines net exports. Finally, the intersection of the N X(²) schedule and the (S − I) schedule determines the real exchange rate. The...