Arnau Canela, Nicole Saizar, Laia Masip, Sílvia Miquel - Group 302

PROBLEM 3 MACRO I

EXERCISE 1

1)

a) Solve for the equilibrium output and money supply during the zero lower bound
period.
Zero lower bond: i*=0
Y*=800-2500i*= 800-2500 x 0 = 800

P=P*=1
Md = P(2Y*-1250i*) = 1(2 x 800 - 1250 x 0) = 1600

b) Consider now an increase in the interest rate to i* = 0.054. What are the new
equilibrium output and money supply?
Y*= 800 - 2500 x 0.054 = 665
Md= 1(2 x 665 - 1250 x 0.054) = 1262,5

c) The Federal Reserve had to sell (buy / sell) billions of government bonds to contract
(contract / expand) the monetary base, and US government bond prices have increased ?
(increased / decreased).

2)

a) Solve for the equilibrium output and money supply in the Eurozone during the ZLB
period, considering your answers for the US in the previous exercise. Assume the UIP
holds.
Y= 100 - 4000 x 0 + 800/4 + 120/1.2 = 400
Md = 1(400 - 50 x 0) = 400

b) According to the UIP, what were the exchange rate expectations E^e during the ZLB
period?
Ee = E * (1 + r - r*)
i = i* = 0
Ee = 1.2 * (1 + 0 - 0) = 1.2

c) Now compute the new equilibrium (output and real exchange rate) after the interest
rate increases to i* = 0.054 and i = 0.045. For your answer, assume that the UIP holds
and that E^e=1.
Y = 100 - 4000 x 0.045 + 665/4 + 120/1 = 206,25
d) Given the exchange rate expectations and the interest rate differentials, the euro
has suffered a depreciation of 17.37% with respect to the dollar.

e) Show graphically in an IS-LM-UIP diagram the equilibrium of the Eurozone

economy at the ZLB and in recent years. Make sure to label clearly curves, axis, and
equilibrium points.

f) Describe in words the developments in the Euro/U.S. dollar exchange rate, output
levels, and nominal interest rates in the Eurozone before and after the increases in the
domestic and foreign interest rates.

When foreign interest rates are higher than those in the Eurozone, it causes capital outflows
from the Eurozone as investors seek higher returns elsewhere. If interest rates in the
Eurozone increase, it leads to capital inflows and depreciation of the Euro.
Low interest rates in the Eurozone encourage more borrowing and investment, stimulating
economic growth. If these rates rise, economic growth slows down.

g) Suppose the ECB decided to fix the exchange rate euro/dollar at EE = EEee=1.
Also, suppose that in its December 2023 meeting, the FED raises interest rates an
additional 100 basis points to reach ii* = 0.064. According to the UIP, what interest rate
should the ECB set? What would the new equilibrium look like in the eurozone? Draw
a diagram to illustrate your answer under this scenario.

i - 0.064 = 1 - 1
i - 0.064 = 0
i = 0.064
The ECB should set the interest rate at 0.064 to maintain the fixed exchange rate.
h) What policy would you recommend to the ECB (flexible or fixed exchange rate) and
why?
I would recommend implementing a flexible policy in order to address situations that
generate economic instability. Additionally, this way, we would avoid economic stagnation
and, therefore, promote economic growth.