Econ 2201 – Winter 2013 – Assignment 4.

Question 1: The small open economy model

Suppose that the economy begins in a position of balanced trade. Use the model of the small open economy to predict what would happen to the trade balance, and the real exchange rate in response to each of the following events.

1. A fall in consumer confidence about the future induces consumers to spend less and save more
2. The introduction of a stylish line of Toyotas make some consumers prefer foreign cars over domestic cars.

Question 2: Consider an economy described by the following equations:

Y = C + I + G + NX

Y = 5,000

G = 1,000

T = 1,000

C = 250 + 0.75 (Y – T)

I = 1,000 – 50 r

NX = 500 – 500ε

r = r* = 5

1. In this economy, solve for national saving, investment, the trade balance, and the equilibrium exchange rate.
2. Suppose now that g rises to 1,250. Solve for national saving, investment, the trade balance and the equilibrium exchange rate. Explain what you find.
3. Now suppose that the world interest rate rises from 5% to 10%. (G is again 1,000.) Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.

Question 3: The Mundell-Flemming model

Assume that the price level is fixed in the short run, both at home and abroad. This means that the nominal exchange rate e equals the real exchange rate. Use the Mundell-Flemming model to predict what would happen to aggregate income and the exchange rate under both floating and fixed exchange rates in response to each of the following shocks.

1. A fall in consumer confidence about the future induces consumers to spend less and save more
1. The introduction of a stylish line of Toyotas make some consumers prefer foreign cars over domestic cars.