MACROECONOMICS

PRACTICAL EXERCISES

Individual
assignment 2
and 3

Nguyễn Thái Lâm_CS170861

MACROECONOMICS PRACTICAL EXERCISES Submission of Individual
Assignments 2 and 3

Your full name: Nguyễn Thái Lâm

Roll Number: CS170861
Class: BA1709

Given the list of events:

a. People change their behavior and reduce their consumption and save more.

b. Business firms are pessimistic about future economic perspectives.

c. Government provides more attractive investment environment.

d. Government decreases its spending on education.

e. Government conducts expansionary fiscal policy.

f. Government conducts contractionary fiscal policy.

g. Government conducts expansionary monetary policy.

h. Government conducts contractionary monetary policy.

i. Government imposes tariff on imported goods.

j. More domestic residents prefer to consume foreign goods.

k. More foreigners prefer to consume domestic goods.

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Table of Contents

ASSIGNMENT 2 3

QUESTION 1. CONSIDER A CLOSED ECONOMY IN THE LONG RUN. FOR EACH OF THE EVENTS FROM(A) TO (H),
EXPLAIN WHAT HAPPENS TO THE REAL INTEREST RATE AND LEVEL OF INVESTMENT IN THE ECONOMY. (SUGGEST:
USE THE LOANABLE FUNDS MARKET FOR A CLOSED ECONOMY) 3

QUESTION 2. CONSIDER A SMALL OPEN ECONOMY WITH FREE CAPITAL MOBILITY IN THE LONG RUN. FOR EACH OF
THE EVENTS FROM (A) TO (K), EXPLAIN WHAT HAPPENS TO THE TRADE BALANCE OF THE ECONOMY. 5

QUESTION 3. CONSIDER A SMALL OPEN ECONOMY WITH FREE CAPITAL MOBILITY IN THE LONG RUN. FOR EACH OF
THE EVENTS FROM (A) TO (K), EXPLAIN WHAT HAPPENS TO THE REAL EXCHANGE RATE AND THE TRADE BALANCE
OF THE ECONOMY. 7

QUESTION 4. CONSIDER A LARGE OPEN ECONOMY WITH FREE CAPITAL MOBILITY IN THE LONG RUN. FOR EACH OF
THE EVENTS FROM (A) TO (K), EXPLAIN WHAT HAPPENS TO THE ECONOMY’S REAL INTEREST RATE, REAL
EXCHANGE RATE, TRADE BALANCE, AND NET FOREIGN INVESTMENT. (SUGGEST: USE THE LARGE OPEN ECONOMY
THREE-PANEL DIAGRAM MODEL) 8

ASSIGNMENT 3 10

QUESTION 1. CONSIDER A CLOSED ECONOMY IN THE SHORT RUN. FOR EACH OF THE EVENTS FROM (A) TO (H),
EXPLAIN WHAT HAPPENS TO THE REAL INTEREST RATE, TOTAL OUTPUT, CONSUMPTION AND INVESTMENT LEVEL IN
THE ECONOMY. 10

QUESTION 2. CONSIDER A CLOSED ECONOMY IN THE SHORT RUN. FOR EACH OF THE EVENTS FROM (A) TO (H),
EXPLAIN WHAT HAPPENS TO THE PRICE LEVEL, TOTAL OUTPUT AND UNEMPLOYMENT IN THE ECONOMY. (SUGGEST:
USE AD-AS MODEL) 12

QUESTION 3. CONSIDER A SMALL OPEN ECONOMY WITH FREE CAPITAL MOBILITY IN THE SHORT RUN. FOR EACH
OF THE EVENTS FROM (A) TO (K), EXPLAIN WHAT HAPPENS TO THE ECONOMY’S EXCHANGE RATE, TOTAL OUTPUT,
CONSUMPTION AND INVESTMENT LEVEL UNDER 15

Question 3a 15

Question 3b 17

QUESTION 4. CONSIDER A LARGE OPEN ECONOMY WITH FREE CAPITAL MOBILITY IN THE SHORT RUN. FOR EACH
OF THE EVENTS FROM (A) TO (K), EXPLAIN WHAT HAPPENS TO THE ECONOMY’S REAL INTEREST RATE, TOTAL
OUTPUT, CONSUMPTION AND INVESTMENT LEVEL UNDER A. THE FLEXIBLE EXCHANGE RATE SYSTEM B. THE FIXED
EXCHANGE RATE SYSTEM. (SUGGEST: USE IS-LM-BP MODEL) 20

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Assignment 2
Question 1. Consider a closed economy in the long run. For each of the events
from(a) to (h), explain what happens to the real interest rate and level of investment
in the economy.
(Suggest: Use the loanable funds market for a closed economy)

Answer:

a) People change their behavior and reduce their consumption and save more.
 Incentivize investment, companies invest more, demand for loans will
increase and pay higher interest. Demand shifts to the right, market
equilibrium shifts vertically supply curve. The result: higher interest rates
and more energy savings.
 For example: At the end of 2022, in the context of global inflation being
more difficult to deal with than initially expected, many central banks have
signaled that they can raise interest rates faster and stronger by the end of
the year. now. Increasing interest rates helps to keep the value of money,
control inflation
b) Business firms are pessimistic about future economic perspectives.
 The change in tax law to reduce electricity savings rather than making
transactions supply curve to the right, the market equilibrium shifts along
the demand curve. As a result, the equilibrium interest rate decreases, and
the equilibrium supply and demand for loanable funds increase.
 Incentivizing more energy savings will result in lower interest rates and
higher investment.
 For example: Businesses expect to reduce interest rates to reinvest. At the
beginning of 2023, the high anchor lending interest rate is causing many
difficulties in the production and business activities of the business

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 community, many businesses are forced to reduce production or do
business in moderation. In that context, many opinions suggest that the
Government and the State Bank should soon have solutions and a roadmap
to reduce interest rates, because with the current lending interest rate above
10%, it is difficult for businesses to maintain efficient production and
business.
c) Government provides more attractive investment environment.
 A budget surplus increases the supply of loanable funds, reduces interest
rates, and encourages investment. Higher investment means more capital
accumulation and faster economic growth than.
 Example: Import, Export, and Investment Incentives in Vietnam. In 2022,
with a strategic geographical location, a competitive labor force, and a
range of cost-saving factors, Vietnam is considered an attractive investment
location for foreign investors. In this context, the Vietnamese government
has been continually improving business conditions through reform and
upgrade of investment incentives, making the country more appealing to
foreign investors. We examine what foreign investors can take advantage of
including the available tax and import/export incentives.
d) Government decreases its spending on education
 As the Government reduces spending on education, perhaps it is creating
more opportunities to spend on other projects. This will lead to a decrease
in demand for loanable funds as the Government's demand for funds will
decrease. Therefore, the supply of loanable funds will increase, causing
banks to lower interest rates. Lower interest rates encourage investment.
Since there is no direct effect on inflation, the real interest rate will also
fall.
e) Government conducts expansionary fiscal policy
 Expansionary fiscal policy: Increase money supply, decrease interest rates,
shifts AD right
 Example: Due to the heavy impact of Covid 19, the Ministry of Finance has
submitted a proposal to approve the policy of developing a decree to extend
the deadline for tax payment and land rent. For corporate income tax, an

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 extension of 3 months is required. For land rent, the ministry proposes to
extend the land rent payable in the first period of 2021 of enterprises,
organizations, business households and individuals eligible for reduction.
f) Government conducts contractionary fiscal policy
 Contractionary fiscal policy: Aiming at narrowing aggregate demand (AD
shifts to the left), reducing money supply, raising interest rates.
 Example: Period 2010 – 2020, in the context of the restored growth rate;
However, it is accompanied by high inflation, and the currency depreciates;
The specific solutions are: Increase state budget revenue from 7-8%
compared to the 2011 budget estimate; Save an extra 10% on regular
spending; Reducing state budget deficit in 2011 to less than 5% of GDP;…
g) Government conducts expansionary monetary policy.
 Aim to expand aggregate demand (AD shifts to the right), increase money
supply, reduce interest rates
 Example: Under the impact of the Covid-19 epidemic, Vietnam has
implemented monetary policy to help reduce financial pressure on
businesses, helping them better adapt to the Covid-19 epidemic. These
measures include lowering interest rates and providing financial support to
businesses. These measures have also been used to reduce returns from the
currency product suite as well as reduce trading in the currency markets.
Vietnam has also created another system to support banks through
restructuring and reducing debt.
h) Government conducts contractionary monetary policy.
 Aims to narrow aggregate demand (AD shifts to the left), reduce money
supply, increase interest rates
 Vietnam has adopted a tight monetary policy to keep the economy stable.
Tight monetary policy has brought the inflation rate from 19.89% in 2008
to 6.52% in 2009, contributing to stabilizing the macro economy. This
policy covers the pricing of state currencies, the management of external

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 corporate currency regulations, and currency transactions in the foreign
exchange market.

Question 2. Consider a small open economy with free capital mobility in the long
run. For each of the events from (a) to (k), explain what happens to the trade
balance of the economy.

(Suggest: Use the loanable funds market for a small open economy)

a. Also as the savings rise, the demand for commodities for personal consumption also
reduces. Thus, the import demand would decrease and the trade balance would increase.

b. Will decrease the demand for investment and as a result, consumption would increase,
thereby increasing the import demand. Thus, there would be a negative impact on the
trade balance.

c. causing a decline in import demand. So, there will be an improvement in the trade
balance.d. a decreased interest rate would induce investment and reduce consumption.
Therefore, there would be an improvement of the trade balance.

e. An expansionary fiscal policy, which is an increase in government spending or a

reduction in taxes, increases the overall demand for goods and services in the economy.
This higher aggregate demand, combined with a reduced demand for investment, would
lead to a rise in consumption demand. This, in turn, would cause imports to increase,
subsequently leading to a deterioration of the trade balance.

f. As a result of higher investment consumption demand would decrease and hence

improve the trade balance.

g. This policy brings down the rate of interest, raising the demand for loanable funds and
thus increasing investment. This leads to a decrease in imports, resulting in an improved
trade balance.

h. This will increase the interest rate and the demand for loanable funds falls. The
increased consumption demand would increase imports and cause the trade balance to
worsen.

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 i. Due to tariffs raising the cost of imported goods, consumers in the local economy opt
for more domestically produced goods. As a result, imports lower and the trade balance is
improved..

j. The rise in the demand for imported goods will lead to an increase in imports. Thus,
the trade balance will worsen.

k. The increased preference for domestic goods will raise exports and hence the trade
balance is increased

Question 3. Consider a small open economy with free capital mobility in the long
run. For each of the events from (a) to (k), explain what happens to the real
exchange rate and the trade balance of the economy.

(Suggest: Use the foreign exchange market for a small open economy)

a. When there is a reduction in consumption and an increase in savings it would lead to a

decline in the exchange rate and a negative trade balance.

b. Business firms are pessimistic about future economic perspectives means that they
would decrease the level of investment

c. This happens because the demand for domestic currency would increase as investors
from anywhere would like to invest, thus resulting in a rise in the exchange rate.

d. This leads to a decline in demand which further causes the demand for the domestic
currency to fall. This influences the exchange rate negatively and thus also causes a trade
deficit.

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e. This results in an increase in demand, investment, and government spending. Thus,
leading to the demand for domestic currency to rise.

f. This decline would lead to lesser demand for the domestic currency leading to a fall in
the exchange rate. This fall in the exchange rate would lead to an unfavorable trade
balance.

g. This will lead to an increase in income, causing imports to rise. This rise in imports
would increase the demand for foreign currency and thus a declining exchange rate. Thus,
leading to an unfavorable balance of trade.

h. This results in lower imports and thus less demand for foreign currency, causing the
exchange rate to rise. This rise leads to a positive trade balance.

i. Tariffs on imported goods cause a decline in imports resulting in a decline in demand

for foreign currency.

j. would increase leading to a rise in the exchange rate resulting in a favorable trade
balance.

k. This would result in a fall in the exchange rate, hence the trade balance also becomes
unfavorable

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Question 4. Consider a large open economy with free capital mobility in the long
run. For each of the events from (a) to (k), explain what happens to the economy’s
real interest rate, real exchange rate, trade balance, and net foreign investment.
(Suggest: Use the large open economy three-panel diagram model)

a. The exports decline to lead to a negative trade balance and indicative depreciation of a
currency. Thus, the net foreign investment also declines due to that.

b. The fall in investment reduces the real interest rate as seen by the fall in NCO. The net
foreign investment would decline as they are pessimistic about taking any investment
decisions.

c. And thus more foreign investment. The rise in the exchange rate results in a positive
trade balance.

d. This would cause the exchange rate to fall and thus a negative trade balance. This
would also decline foreign investment due to poor labor productivity.

e. And thus, resulting in a favorable balance of trade. This would also have a positive
foreign investment.

f. Thus leading to a negative trade balance. And would also have a decline in the level of
foreign investment.

g. This rise in imports would increase the demand for foreign currency and thus a
declining exchange rate. Thus, leading to a negative trade balance.

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h. This would decline the income levels. This results in lower imports and thus less
demand for foreign currency, causing the rise leads to a positive trade balance, which in
turn has a positive impact on the levels of foreign investments.

i. This would create an environment so that the foreign investment levels rise.

j. This favorable trade balance helps foreign investment to rise.

k. Imports fall, resulting in a decline in foreign currency demand. This would result in a
fall in the exchange rate; hence the trade balance also becomes unfavorable. The foreign
investment situation deteriorates as per the conditions created.

Assignment 3

Question 1. Consider a closed economy in the short run. For each of the events from
(a) to (h), explain what happens to the real interest rate, total output, consumption
and investment level in the economy.
(Suggest: Use IS-LM model)

a) People change their behavior and reduce their consumption and save more.
When savings increase and consumption decreases, the IS curve shifts leftward,
causing a decline in the real interest rate and total output in the economy. The
decrease in consumption demand leads to a decrease in production, while the

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 increase in saving results in more loanable funds being supplied, leading to a
reduction in the interest rate.
b) Business firms are pessimistic about future economic perspectives.
When individuals have negative expectations about the future, their tendency to
invest decreases, which in turn moves the IS curve to the left. Consequently, banks
would lower their interest rates for loanable funds due to the lack of investors. This
leads to a decrease in real interest rates. As a result of reduced investment in the
economy, economic activity, total output, and consumption all decline.
c) Government provides more attractive investment environment.
An increase in the investment environment's attractiveness will cause consumers to
lean towards increasing their investments, leading to a shift of the IS curve to the
right. This shift will result in a shortage of loanable funds and a subsequent rise in
real interest rates. This increase in economic activity will also lead to a rise in total
output and consumption, ultimately resulting in a robust economy characterized by
higher real interest rates, increased total output, and higher consumption and
investment levels.
d) Government decreases its spending on education.
If the government reduces its spending on education, it will cause a shift to the left
in the IS curve. Consequently, the real interest rate will decrease, leading to a
decline in real output and consumption. Nonetheless, investors will be encouraged
to invest due to the fall in the interest rate.
e) Government conducts expansionary fiscal policy.
When the government implements an expansionary fiscal policy, the IS curve
shifts to the right, resulting in an increase in the national income. As a result of this
increase in income, there is a subsequent rise in the demand for money which
increases the real interest rate. This increase in real interest rates leads to an
increase in total output and consumption in the economy. However, with higher
interest rates, private investment is likely to decrease.
f) Government conducts contractionary fiscal policy.
The government is implementing a contractionary fiscal policy that is focused on

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 decreasing economic activity. This policy will cause the IS curve to shift leftward,
leading to a decrease in national income. As a result, the demand for money will
decrease, causing the real interest rate to decline. With the decline in the real
interest rate, there will also be a downward trend in total output and consumption.
Despite this, the lower interest rates will result in increased investment in the
economy.
g) Government conducts expansionary monetary policy.
Expansionary monetary policy refers to the increase in the money supply (Ms) in
the economy, which leads to a rightward shift of the LM curve. As a consequence,
the real interest rate decreases, and both total output and consumption increase.
Lower interest rates also stimulate investment.
h) Government conducts contractionary monetary policy.
Contractionary monetary policy results in a leftward shift of the LM curve, causing
an increase in the real interest rate. This ultimately leads to a decrease in total
output and consumption. Furthermore, the higher interest rate reduces investment.

Question 2. Consider a closed economy in the short run. For each of the events from
(a) to (h), explain what happens to the price level, total output and unemployment in
the economy. (Suggest: Use AD-AS model)

The aggregate demand (AD) curve depicts the relationship between the price, real
GDP demanded by households, firms, and the government. It is based on the real
GDP. The real GDP (Y) has three components: Consumption(C), Investment (I),
and Public Spending (G).

Y=C+I+G

a) People change their behavior and reduce their consumption and save more.
When consumers reduce their consumption and increase their savings, it suggests
that they anticipate higher prices in the future and therefore prioritize future

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 consumption over present consumption. This shift in behavior results in a leftward
movement of the AD curve, indicating a decrease in the quantity of real GDP
demanded.
The displayed phenomenon illustrates the wealth effect, where an increase in the
price level (or anticipation of price inflation) causes a decrease in the real value of
household wealth. As a result, people consume less and save more in an effort to
maintain their minimum consumption level. This reduction in consumption leads to
a decrease in supply and ultimately results in unemployment.
b) Business firms are pessimistic about future economic perspectives.
Business firms are pessimistic about future economic perspectives decrease the
investment. This happens because of the expectation that the future profitability of
their investment would fall. This change shifts the AD curve leftwards. This shows
the decrease in real GDP due to the declining investment spending. This would
lead to a decline in supply and thus result in unemployment.
c) Government provides more attractive investment environment.
A creation of attractive investment would mean a rise in investment spending. This
will cause an increase in the real GDP, meaning the output (or demand) rises. This
change will result in a shift in the AD curve towards the right indicating an
increase in the level of real GDP. This would increase the supply and thus increase
employment.
d) Government decreases its spending on education.
If spending on education were to decrease, it would result in a decline in
government spending and a decrease in real GDP. This decline would cause the
AD curve to shift leftwards. However, such a decrease would also lead to a
reduction in productivity of the labor force, which would shift the AS curve to the
left due to increased production costs (including the cost of training workers to
make them productive). As a result, the equilibrium point would shift and indicate
an increase in the price level, a decrease in output, and an increase in
unemployment.
e) Government conducts expansionary fiscal policy.

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 An expansionary fiscal policy, conducted by the government, involves an increase
in government spending, a reduction in taxes or both. As a result of this policy, real
GDP increases due to higher consumption, investment and government spending.
Consequently, there is a rightward shift in the AD curve, which leads to an increase
in supply due to the demand situation. This shift, in turn, leads to an increase in
employment as well.
f) Government conducts contractionary fiscal policy.
When the government conducts contractionary fiscal policy, it means that it
reduces its spending and/or increases taxes to reduce the aggregate demand in the
economy.
In the short run, this results in a decrease in total output and an increase in
unemployment as firms cut back on production and lay off workers.
Using the AD-AS (Aggregate Demand-Aggregate Supply) model, we can see that
the contractionary fiscal policy shifts the AD curve to the left. The shift in AD
leads to a decrease in both output and the price level, but an increase in
unemployment. The AS curve shows that there is a short-run equilibrium point
where the AD curve intersects the AS curve. When the AD curve shifts leftward, it
will intersect with the AS curve at a lower level of output and a lower price level.
g) Government conducts expansionary monetary policy.
Expansionary monetary policy is a policy undertaken by the government to
increase the money supply in the economy in order to stimulate economic growth.
This can lead to changes in the economy's overall level of economic activity, as
measured by the price level, total output, and unemployment.
As the AD curve shifts to the right, it leads to an increase in both the price level
and total output. This represents an expansion of the economy, as output increases
to meet the increased demand for goods and services.
At the same time, the increase in economic activity leads to a decrease in
unemployment as firms increase their production and hire more workers to meet
the rising demand.
h) Government conducts contractionary monetary policy.

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 When the government conducts contractionary monetary policy, the central bank
reduces the money supply by increasing interest rates.
In the AD-AS model, a reduction in the money supply causes a leftward shift in the
aggregate demand (AD) curve. This shift leads to a decrease in the equilibrium
level of output and an increase in the price level.
As a result, the contractionary monetary policy leads to a decrease in total output
and an increase in the price level. This will cause a movement along the aggregate
supply (AS) curve towards a point with a lower quantity of output and a higher
price level.

Question 3. Consider a small open economy with free capital mobility in the short
run. For each of the events from (a) to (k), explain what happens to the economy’s
exchange rate, total output, consumption and investment level under
a. the flexible exchange rate system
b. the fixed exchange rate system.
(Suggest: Use Mundell-Fleming model)

Question 3a

a. When people start to save more in the economy by reducing their consumption
expenditure, the IS curve will fall and shift towards the leftward direction. The
real interest rate will fall, this will induce an outflow of capital from the home
country to the international world. As the exchange rates are flexible, the XR will
fall, that is, the home economy's currency will depreciate.

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b. When the businesses in the economy are having pessimistic views about the
economy’s future, the investment expenditure will fall. This will cause the IS to
fall and shift towards the leftward direction. The real interest rate will fall, this
will induce an outflow of capital from the home country to the international
world.

c. When the government provides an attractive environment for investment, the

investment expenditure will rise. This will cause the IS to rise and shift towards
the rightward direction. The real interest rate will rise, this will induce an inflow
of capital to the home country from the international world. As the exchange rates
are flexible, the XR will rise, that is, the home economy's currency will
appreciate. This will cause the value of net exports to fall, as the appreciation will
cause the exports to decline and imports to increase.

d. When the government decreases its investment in the education sector. This
will cause the IS to fall and shift towards the leftward direction. The real interest
rate will fall, this will induce an outflow of capital from the home country to the
international world. As the exchange rates are flexible, the XR will fall, that is,
the home economy's currency will depreciate.

e. When the government adopts a fiscal policy that is expansionary in nature.

This will cause the IS to rise and shift towards the rightward direction. The real
interest rate will rise, this will induce an inflow of capital to the home country
from the international world. As the exchange rates are flexible, the XR will rise,
that is, the home economy's currency will appreciate.

f. When the government adopts a fiscal policy that is contractionary in nature.

This will cause the IS to fall and shift towards the leftward direction. The real
interest rate will fall, this will induce an outflow of capital from the home country
to the international world. As the exchange rates are flexible, the XR will fall, that
is, the home economy's currency will depreciate.

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g. When the government adopts a monetary policy that is expansionary in nature.
This will cause the LM to rise and shift towards the rightward direction. The real
interest rate will fall, this will induce an outflow of capital from the home country
to the international world. As the exchange rates are flexible, the XR will fall, that
is, the home economy's currency will depreciate.

h. When the government adopts a monetary policy that is contractionary in nature.

This will cause the LM to fall and shift towards the leftward direction. The real
interest rate will rise, this will induce an inflow of capital to the home country
from the international world. As the exchange rates are flexible, the XR will rise,
that is, the home economy's currency will appreciate.

i. When the government imposes a tariff on imports in the economy. The rise in
the tariff rate on imports will cause the demand for domestic commodities to rise.
This will cause the IS to rise and shift towards the rightward direction. The real
interest rate will rise, this will induce an inflow of capital to the home country
from the international world. As the exchange rates are flexible, the XR will rise,
that is, the home economy's currency will appreciate. This will cause the value of
net exports to fall, as the appreciation will cause the exports to decline and
imports to increase.

j. The number of home country’s citizens preferring foreign country’s

commodities has increased. So, the import demand of the country has risen. So,
the net exports will fall creating an excess supply of goods in the economy. The
IS curve will fall and shift towards the leftward direction. The real interest rate
will fall, this will induce an outflow of capital from the home country to the
international world. As the exchange rates are flexible, the XR will fall, that is,
the home economy's currency will depreciate.

k. The number of foreign citizens preferring the home country’s commodities has

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 increased. So, the export demand of the country has risen. So, the net exports will
rise creating an excess demand for goods in the economy. This will cause the IS
to rise and shift towards the rightward direction. The real interest rate will rise,
this will induce an inflow of capital to the home country from the international
world. As the exchange rates are flexible, the XR will rise, that is, the home
economy's currency will appreciate.

Question 3b
a. When people wish to save more and consume less: Under a fixed ER system,
there is no impact on the ER (exchange rate) of the economy. The level of
investment and consumption in the economy falls as people save more leading to
a leftward shift in the IS curve. As the IS curve shifts to the left, the interest rates
will fall. There will be capital outflow in the economy.
b. The pessimistic nature of individuals: This means that they are not very
confident about future perspectives like making an investment or consumption.
That is, pessimistic nature leads to reduced demand and a fall in investment.
Under a fixed exchange rate(FER) and perfect capital mobility(PCM), the ER of
the economy will remain unchanged. The level of investment and consumption in
the economy will fall as the businesses are

pessimistic about the future profits, that is, they lack confidence regarding the
profits that they will achieve in the future. This will shift the IS curve to the left
leading to a fall in total output in the economy. The interest rates will be lower
than the world interest rates and therefore, the economy will face capital outflow.

This will cause the LM curve to shift towards the right and increase the interest
back to the original level. An increase in the money supply will lead to a fall in
interest rates. Lower interest rates attract more investments in the economy. As
the original interest rates are recovered, the capital inflow stops, and exchange
rates are back at the original equilibrium level. Due to the increase in both

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investment as well as money supply in the economy, national income or output
and consumption have increased. There is more money induced in the system
which increases all the macroeconomic variables such as consumption investment
and output while keeping exchange rates constant.

c. This leads to a depreciation of the domestic currency and an exchange rate

fall. But, since it is given that the exchange rates are fixed, the central bank will
decrease the money supply to meet the reduced money demand which causes a
leftward shift in the LM curve.

This will cause the interest rates to increase. A decrease in the money supply will
decrease the supply of domestic currency in the market thereby increasing its
price. This will bring the value of the domestic currency to appreciate and
therefore increase the exchange rate back to the original level. Therefore, a fall in
government expenditure will lead to a fall in national income, consumption as
well as investment level while keeping the exchange rate at the same level.

d. In order to keep the exchange rates fixed, the central bank will increase the
money supply causing the LM curve to move towards the right. This will bring
the interest rates back to the original level, i.e., the world interest rate levels. This
will keep the exchange rates level at the original level while increasing the
national income/output, consumption as well as investment level. Therefore,
expansionary fiscal policy leads to an increase in the investment, consumption,
and national output levels.
e. . This will lead to a fall in the level of interest rates. New domestic interest
rates will be lower than the world interest rates. Lower interest rates will push
domestic investors to invest in foreign markets causing a capital outflow. This
will increase the demand for a foreign currency more than the demand for
domestic currency. As a result, the exchange rate will depreciate. To maintain the
exchange rate at a fixed level, the central bank will reduce the money supply. A

19
lower supply of money will cause the LM curve to shift towards the left. This will
increase the interest rates level to the original level and therefore restore the
original level of exchange rates. But a new higher interest rate leads to lower
investment. Capital flows in, the demand for the domestic currency will increase
and so will its price. As the domestic currency increases in value, the exchange
rate appreciates. To keep the exchange rate fixed at a given level, the central bank
will increase the supply to reduce the value of the currency. An increase in money
supply will leave the people with more money to invest as well as for
consumption. Therefore, an increase in import tariff will increase investment,
consumption as well as national output level but will keep the ER at the same
level.
f. More domestic residents prefer to consume foreign goods: As the preference
of the consumers for foreign commodities increases, imports in the economy will
increase. This will cause a decrease in net exports. As the net exports fall, the IS
curve will move towards the left. This will induce capital to flow out from the
market as the interest rates will fall due to the shift. But the national output,
investment, and consumption will all reduce in value.
g. More foreigners prefer to consume domestic goods: This will lead to an
increase in exports in the economy. The net exports increase, shifting the IS curve
to the rightl. As the equilibrium is restored in the domestic financial market, the
exchange rate will fall back to the original level. As the money supply has now
increased, individuals have more money for consumption as well as investment
purposes. The overall national output will also increase. Therefore, an increase
in exports will increase investment, consumption, output level, while keeping
exchange rates fixed.

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Question 4. Consider a large open economy with free capital mobility in the short
run. For each of the events from (a) to (k), explain what happens to the economy’s
real interest rate, total output, consumption and investment level under a. the
flexible exchange rate system b. the fixed exchange rate system. (Suggest: Use IS-
LM-BP model)
a) People change their behavior and reduce their consumption and save more.
 Under a flexible exchange rate system, an increase in saving leads to a
decrease in consumption, which reduces aggregate demand and leads to a
decrease in the overall price level. This causes the currency to appreciate,
which results in a decrease in net exports as exports become more
expensive and imports become cheaper. The decrease in net exports further
reduces aggregate demand and total output. The increase in saving also
increases the supply of loanable funds, leading to a decrease in the real
interest rate. This decrease in the real interest rate stimulates investment,
which helps to offset some of the reduction in output caused by the
decrease in consumption and net exports.
 Under a fixed exchange rate system, the central bank is committed to
maintaining a pegged exchange rate, so if the currency appreciates due to
increased savings there will be an increase in demand for the domestic
currency to maintain the peg. This can only be accomplished through the
central bank printing more currency. As a result, an increase in savings
could lead to inflation and a decrease in purchasing power, which could
offset any positive effects of increased saving on investment levels.
 In conclusion, in a flexible exchange rate system, a increase in saving leads
to a decrease in the real interest rate, total output, consumption, and
investment level, while in a fixed exchange rate system, the outcomes are
less clear and depend on the particular situation.
b) Business firms are pessimistic about future economic perspectives.
 a. Under a flexible exchange rate system, if business firms become
pessimistic about future economic perspectives, there may be a decrease in

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 investment levels, leading to a decrease in total output and consumption. As
private investment decreases, the demand for loanable funds decreases and
the real interest rate decreases. The decrease in investment will also lead to
a decrease in aggregate demand, which will ultimately result in a decrease
in the equilibrium output level.
 b. Under a fixed exchange rate system, the central bank will intervene in
the foreign exchange market to maintain the pegged exchange rate. If
business firms become pessimistic about future economic perspectives,
there may be a decrease in investment levels, leading to a decrease in the
total output and consumption. As private investment decreases, the demand
for loanable funds will decrease and the real interest rate will decrease. The
decrease in investment and aggregate demand will cause a recession and
may prompt the central bank to lower interest rates to boost economic
activity. However, due to the fixed exchange rate system, the central bank's
ability to adjust the interest rate is limited, which may worsen the economic
situation.
c) Government provides more attractive investment environment.
 a. Under a flexible exchange rate system, when the government provides a
more attractive investment environment, foreign investors will want to
invest in this economy, resulting in an increase in demand for the domestic
currency. This will cause the exchange rate to appreciate, which in turn will
lead to a decrease in net exports. The increase in investment will result in
an increase in the demand for loanable funds, which will drive up the real
interest rate. The higher real interest rate will cause a decrease in
consumption and investment, ultimately leading to a decrease in total
output.
 b. Under a fixed exchange rate system, the exchange rate remains fixed,
even if the government provides a more attractive investment environment.
In this case, the increase in investment will lead to an increase in the
demand for loanable funds, which will again drive up the real interest rate.

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 However, this increase in the real interest rate will not cause a decrease in
consumption and investment, as the exchange rate remains fixed. Instead, it
will cause a decrease in net exports, leading to a decrease in total output.
d) Government decreases its spending on education.
 a. Under a flexible exchange rate system, the decrease in government
spending on education would likely result in a decrease in the economy's
total output as government spending often spurs economic growth. As a
result, consumption and investment levels could also decrease, leading to a
lower demand for loanable funds. This would cause the real interest rates to
decline.
 b. In a fixed exchange rate system, the central bank would likely try to
maintain the exchange rate by adjusting the money supply. Therefore, to
compensate for the decrease in government spending on education, the
central bank could increase the money supply, increasing total output,
consumption and investment levels. This process could potentially increase
the demand for loanable funds, leading to a rise in real interest rates.
e) Government conducts expansionary fiscal policy.
 a. Under a flexible exchange rate system, the government's expansionary
fiscal policy will lead to an increase in the demand for domestic goods and
services. This, in turn, leads to an increase in the demand for domestic
currency, resulting in an appreciation of the currency. As a result, the real
interest rate in the economy will rise and the investment level may
decrease. However, since the increase in demand for domestic goods also
increases total output, consumption may also increase.
 b. Under a fixed exchange rate system, the government's expansionary
fiscal policy will lead to an increase in the demand for domestic goods and
services, leading to an increase in imports. This increase in imports creates
a balance-of-payments deficit, which will lead to a reduction in the foreign
reserves held by the central bank. To maintain the fixed exchange rate, the
central bank will need to intervene and sell foreign reserves, increasing the

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 money supply and causing inflation. This inflation increases the nominal
interest rate, but the real interest rate will fall due to the increase in
inflation. This will lead to an increase in total output and consumption,
while the investment level may remain relatively unchanged or decrease
slightly.
f) Government conducts contractionary fiscal policy.
 a. Under a flexible exchange rate system, a contractionary fiscal policy by
the government leads to an increase in the national savings, as the
government is reducing its expenditures. The increase in savings leads to a
decrease in the real interest rate in the economy, which in turn stimulates
investments by reducing the cost of borrowing and increasing total output.
However, with free capital mobility, the decrease in the interest rate in this
economy compared to other economies leads to a capital outflow, which
puts downwards pressure on the exchange rate causing it to depreciate. The
depreciation of the exchange rate increases net exports, which offsets some
of the negative impact of contractionary fiscal policy on the economy's total
output, while consumption may decrease due to the policy's contractionary
effect.
 b. Under a fixed exchange rate regime, the central bank will have to
intervene in the foreign exchange market to keep the exchange rate fixed.
This, in turn, means that the central bank will need to raise interest rates to
make the domestic currency more attractive to investors, and the decrease
in the money supply from fiscal contraction means that there is less money
available at higher interest rates to invest. This leads to a decrease in
investments, total output, and consumption.
g) Government conducts expansionary monetary policy.
 Assuming that the expansionary monetary policy leads to a decrease in the
interest rate, the effects on the different macroeconomic variables would be
as follows:

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  a. Flexible Exchange Rate System: Under a flexible exchange rate
system, the currency value is determined by market forces, so a decrease in
interest rates makes domestic bonds less attractive and could cause capital
outflows, decreasing the value of the domestic currency. This depreciation
of the currency would lead to an increase in net exports, which would
stimulate total output, consumption and investment, as domestic goods
become cheaper for foreign buyers. Thus, in the short run, the real interest
rate would decline, total output would increase, and consumption and
investment would rise.
 b. Fixed Exchange Rate System: In a fixed exchange rate system, the
government will have to maintain the exchange rate by buying or selling
domestic currency in the foreign exchange market. Thus, an expansionary
monetary policy could lead to a short-term increase in demand for domestic
currency, which would increase the value of the currency. This, in turn,
would lead to a decrease in net exports, as foreign goods become cheaper
for domestic buyers, and would offset the stimulative effect of the
expansionary monetary policy. Therefore, in the short run, the real interest
rate may decline slightly, but total output, consumption and investment are
unlikely to show significant changes.
h) Government conducts contractionary monetary policy
 a. Flexible exchange rate system: In a flexible exchange rate system, the
contractionary monetary policy leads to an increase in interest rates which
attracts more foreign capital into the domestic economy causing the
domestic currency to appreciate. The appreciation of the currency makes
exports more expensive and imports cheaper, and hence the net exports
decrease. The decrease in net exports leads to a decrease in the total output,
consumption, and investment level.
 b. Fixed exchange rate system: In a fixed exchange rate system, the
government has to intervene in the foreign exchange market to maintain the
fixed exchange rate. To do so, the government will have to sell its foreign

25
 exchange reserves to maintain the value of the domestic currency. This
selling of reserves would lead to a contraction of the domestic money
supply, causing an increase in the interest rates. The increase in interest
rates leads to a decrease in total output, consumption, and investment level.
 In summary, under both exchange rate systems, the contractionary
monetary policy leads to an increase in interest rates, which causes a
decrease in total output, consumption, and investment level.
i) Government imposes tariff on imported goods.
 a. Under the flexible exchange rate system, the imposition of tariffs on
imported goods will lead to an increase in the demand for domestic goods
and a decrease in the demand for foreign goods. This will lead to an
increase in the demand for the domestic currency, causing its value to
appreciate. As a result, the real interest rate in the economy will decrease,
stimulating investment and consumption. However, the appreciation of the
domestic currency may also lead to a decrease in total output as exports
become more expensive, and this may offset some of the positive effects on
investment and consumption.
 b. Under the fixed exchange rate system, the central bank will need to
intervene to maintain the exchange rate at the fixed level. The imposition of
tariffs on imported goods may lead to an increase in the demand for the
domestic currency, causing its value to appreciate. The central bank will
need to sell domestic currency to maintain the fixed exchange rate, leading
to an increase in the money supply. This can lead to inflation and a decrease
in the real interest rate, which may stimulate investment and consumption.
However, over the long run, the increase in the money supply may also lead
to a decrease in total output and potentially harm the economy.
j) More domestic residents prefer to consume foreign goods.
 a. Under a flexible exchange rate system, an increase in preference for
foreign goods would lead to an increase in demand for foreign currency,
causing the domestic currency's value to depreciate. The depreciation of the

26
 domestic currency would lead to an increase in the economy's real interest
rate as the cost of foreign borrowing increases. The appreciation of foreign
goods would lead to a decrease in total output, as domestic producers will
face more competition from foreign goods. Consumption levels would
increase as domestic residents prefer foreign goods over domestic goods.
However, investment levels would decrease, as firms face more
competition from foreign firms, leading to lower profits and less
investment.
 b. Under a fixed exchange rate system, the central bank will intervene in
the foreign exchange market to maintain a fixed exchange rate. An increase
in preference for foreign goods would lead to an increased demand for
foreign currency, and the central bank will use its foreign exchange
reserves to maintain the exchange rate, leading to a decrease in the money
supply. This would lead to an increase in the economy's real interest rate,
which would reduce consumption and investment levels, leading to a
decrease in total output. Therefore, a fixed exchange rate system may result
in more significant fluctuations in an economy as compared to a flexible
exchange rate system.
k) More foreigners prefer to consume domestic goods.
 a. Under a flexible exchange rate system, an increase in foreign demand
for domestic goods will lead to an appreciation of the domestic currency.
This will lower the price of imports and increase the price of exports,
making domestic goods relatively more expensive for foreigners and
foreign goods relatively cheaper for domestic buyers. As a result, total
output and consumption may increase, while investment levels may
decrease due to higher interest rates caused by capital inflows seeking to
take advantage of the higher return on investment in the domestic economy.
 b. On the other hand, under a fixed exchange rate system, the central bank
will have to intervene to maintain the fixed exchange rate. This will require
an increase in the money supply, which in turn will lower the interest rates

27
and increase investment levels. The increase in demand from foreign buyers
will cause an increase in total output and consumption, but at the expense
of higher inflation rates in the long run.

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