MACROECONOMICS PRACTICAL EXERCISES

Submission of Individual Assignment 2 and 3

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.

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)
(a) People alter their behavior; they consume less, save more, and make fewer
investments. Savings will increase the amount of loanable cash. As a result, nominal
interest rates would drop. Inflation would continue to decline if it remained at its current
rate.
(b) Businesses that have gloomy predictions for the state of the economy will contribute
less capital to the system, making more money accessible for lending. As a result, banks
are compelled to lower interest rates, which lowers the real interest rate and has no
influence on inflation.
(c) When the government offered attractive investment opportunities, the economy would
witness an increase in investments. Less money would be available for loans as a result of
the increasing demand. Banks would thus need to boost interest rates. Since there would
be no direct impact on inflation, the real interest rate would also rise.
(d) Less money is spent by the government on education. Less loanable money would be
needed by the government. As a result, when the amount of money available for lending
rises, banks' interest rates fall. Growth in investments will be encouraged by low-interest
rates. Since inflation would not change, the actual interest rate would also go down.
(e) An expansionary fiscal strategy increases the government's debt by necessitating
borrowing. Subsequently pushing out private businesses. Interest rate hikes in the
economy will lead to an increase in investment levels. Since there won't be a direct
influence on inflation, the actual interest rate will also increase.
(f) By lowering the government budget deficit, a contractionary fiscal policy lowers
government borrowing. There would be more money available for loans. The interest rate
will decrease as development increases. This would also result in a decrease in the real
interest rate because it has no direct effect on inflation.
(g) An expansionary monetary policy increases the money supply and loanable funds.
Investment will increase as interest rates decline. The expansionary monetary policy of
the government will almost certainly lead to increased final product prices. The real
interest rate would consequently decrease.
(h) A contractionary monetary policy reduces the amount of money available for loans.
Investment decreases when interest rates rise. As a result, prices decline, and since the
real interest rate is growing, inflation may happen.
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) The economy will have access to more loanable capital if consumers change their
spending habits and save more money, which will result in a decrease in nominal interest
rates. As people save more money, the market for things intended for personal use
becomes less. Because there would be less of a need for imports, the trade balance would
increase.
(b) Business firms are pessimistic about future economic perspectives, and investors will
start to concentrate more on foreign markets. Imports will be more necessary as
investment declines and demand rises. The trade balance will deteriorate as a result.
(c) The government fosters an environment that encourages investment. An environment
that is more conducive to investing will attract both domestic and overseas investors.
Consequently, higher investment will lower consumption and lessen the need for imports.
The trade balance will therefore get better.
(d) More money will be available for loans while the Government decreases its spending
on education. A lower interest rate would therefore encourage investment and save
money. As a result, the trade balance would get better.
(e) An expansionary fiscal policy raises total demand throughout the economy. If demand
was higher overall and there was less need for investments, there would be a greater
desire for consumption. As a result, imports will increase and the trade deficit will widen.
(f) The government implements a fiscally contractionary policy. The contractionary fiscal
policy reduces the cost of loanable money by cutting interest rates. If higher investment
resulted in lower demand for consumption, the trade balance would get better.
(g) Monetary expansion is implemented by the government. This tactic fosters
investment, drives down interest rates, and boosts demand for loanable funds. Imports
fall as a result, and the trade balance gets better.
(h) The government employs contractionary monetary policy. This strategy increases
demand for loanable funds, encourages investment, and lowers interest rates. As a result,
imports decrease and the trade balance improves.
(i) Tariffs increase the price of imported goods, increasing the appeal of domestic goods
to consumers. As a result, imports decrease and the trade balance improves.
(j) Imports rise to meet demand as a result of consumer preferences for imported goods.
The trade balance will deteriorate as a result.
(k) Exports will increase and the trade balance will improve as consumers grow more
interested in homegrown goods.
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) People change their behavior reduce their consumption and save more. A decline in
consumption and an increase in savings would lead to a negative trade balance and a drop
in the exchange rate.
(b) Business organizations have a negative outlook on the state of the economy. After
that, there would be less of a demand for money, which would cause the exchange rate to
decline and the trade balance to go negative.
(c) The government fosters an environment that encourages investment. The exchange
rate would increase and the trade balance would be positive as a result of increased
demand for the currency. A positive trade balance would arise from the increasing
exchange rate, which is a consequence of the growing demand for the currency.
(d) When the government reduces funding for education while increasing investment in
another sector. As a result, both prices and production costs increase. As a result, demand
declines, hence decreasing demand for the national currency. As a result, there is a trade
imbalance, and the currency rate declines.
(e) The government implements an expansive fiscal strategy. Demand, investment, and
government spending all increase as a result. The desire for local currency has increased
as a result. The rise in the exchange rate will lead to an improvement in the trade balance.
(f) A fiscal contraction program is implemented by the government. The demand for the
local currency would decline as a result of this downturn, lowering the exchange rate. An
adverse trade balance would result from the decline in exchange rates.
(g) The government raises revenue by implementing an expansionary monetary policy,
which raises imports. The demand for foreign currency would rise with an increase in
imports, which would result in a decrease in the exchange rate, leading to a negative trade
balance.
(h) Lowering income is a result of the government's contractionary monetary policy.
Decreased imports raise the exchange rate because they reduce the need for foreign cash.
A positive trade balance results from this increase.
(i) Import taxes cause a drop in imports, which reduces the requirement for foreign
currency. Consequently, there is a decline in the currency rate and a negative trade
balance.
(j) As a result of more local citizens choosing to purchase items from abroad, there will
be a rise in imports, which will raise the demand for foreign currency, produce a positive
trade balance, and raise the exchange rate.
(k) Import levels fall and the need for foreign currency decreases as more foreigners opt
to buy domestic goods. This would result in a decline in the exchange rate, which would
also negatively impact the trade balance.
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 economy has more loanable money since people are saving more and consuming
less. The real interest rate falls as the amount of loanable cash increases. The trade
balance shifts in favor of surplus as a result of the increased savings and consequent
decrease in spending. Reducing the need to borrow from foreign investors is another
benefit of the rise in domestic savings.
(b) Business organizations have a pessimistic outlook for the economy, which would
cause the real interest rate to decline. Exchange rates would also fall as a result, as would
the value of the currency. As a result, there would be a rise in imports and a negative
trade balance. As evidenced by the decline in net capital outflow, there is little question
that a reduction in investment lowers the real interest rate. Net foreign investment would
drop in amount.
(c) The government raises the value of the currency by creating an environment that
draws in more investors. Foreign investment increased as a result. A positive trade
balance is the outcome of the increase in exchange rates.
(d) Less money is spent by the government on education. The decline in exchange rates
would result in a negative trade balance. Reduced foreign investment would also result
from low worker productivity.
(e) Government conducts expansionary fiscal policy. As a result, there would be more
chances for investment, which would raise exchange rates and produce a positive trade
balance. This would also encourage international investment.
(f) The government implements a fiscally contractionary policy. Exchange rates would
decline as a result of the investment amount falling. resulting in a trade balance deficit
and a drop in international investment.
(g) Government conducts expansionary monetary policy. As a result, both imports and
revenue would increase. Because there would be greater demand for foreign currency, an
increase in imports would result in a decrease in the exchange rate. Leading to a negative
trade balance and decreased investment in foreign.
(h) Contractionary monetary policy is implemented by the government. As a result,
revenue will decrease. Lower imports lead to a decrease in the requirement for foreign
currency, which drives up the exchange rate. This kind of rise leads to a positive trade
balance, which encourages foreign investment.
(i) The government imposes a tariff on imported goods. Increasing the exchange rate and
a favorable trade balance. This would foster an atmosphere that would encourage more
foreign investment.
(j) More domestic residents prefer to consume foreign goods. A positive trade balance is
the outcome of an increase in demand for foreign money, which raises the exchange rate.
The favorable trade balance encourages foreign investment.
(k) More foreigners prefer to consume domestic goods. This implies a decrease in
imports, which lessens the requirement for foreign exchange. The exchange rate would
decline and the trade balance would go negative as a result. The circumstances that have
developed point to a drop in foreign investment.
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 changing their behavior reducing their consumption and saving more would
lead to a fall in aggregate demand. Since consumption is a part of aggregate demand, a
decline in consumption would lead to a fall in overall economic spending, which would
cause the IS curve to move to the left. This change in the IS curve would lead to a
decrease in overall output and investment.
(b) Business firms are pessimistic about future economic perspectives. As a result of this
drop in investment demand, the IS curve moves to the left. As a result, output volume
decreases at every interest rate. This implies that in the short term, income will be at a
lower equilibrium level. According to the IS-LM model, a decline in investment causes
the real interest rate to decline.
(c) The government creates an atmosphere that is more conducive to investment. To
reflect rising investment levels at each interest rate level, the IS curve in the IS-LM
model would therefore shift to the right. As a result, the equilibrium real interest rate
would increase. Demand increases lead to higher production, which boosts total output.
Businesses are encouraged to spend more on investments when the investment climate is
more favorable, as was previously mentioned. Consequently, financial investment would
increase.
(d) When the government reduces its spending on education. This will cause the IS curve
to shift to the left. The real interest rate will initially decrease as a result of the loss in
output and the subsequent decline in investment demand. There may be a slight decrease
in consumption. Investment will most likely decrease as businesses begin to be more
cautious with their capital allocation.
(e) The government employs expansionary fiscal policy, which entails lowering taxes or
raising spending, to boost aggregate demand. The IS curve rises when economic spending
rises as a result of lower taxes or higher government spending. The real interest rate will
rise as a result of this increase in the nominal interest rate. Increases in disposable income
are accompanied by increases in consumption. Investment is encouraged as businesses
look to increase their manufacturing capacity due to growing output and increased
demand.
(f) When the government conducts contractionary fiscal policy and shifts the IS curve to
the left because there is less overall demand in the economy. Higher taxes also shift the IS
curve to the left as consumers have less disposable income to spend, reducing overall
demand. The LM curve is not immediately impacted by more restrictive fiscal policy. The
contractionary fiscal policy has reduced demand in the economy, which causes the IS
curve to move to the left and lower output. The real interest rate decreases as a result of
this drop in output since there is less demand for loanable money. Tax increases reduce
households' disposable income, which limits their ability to spend and consequently
reduces consumption. A drop in output and interest rates may lead to a decrease in
investment. Due to the reduced predicted profits in a weaker economy, businesses may be
less willing to invest in new projects.
(g) Should the government pursue an expansionary monetary policy, interest rates will
drop. The LM curve tilts downward as a result. Cutting interest rates encourages
investment and consumption for two reasons: they cut borrowing costs and create a
disincentive to save money. The IS curve shifts to the right as a result of rising investment
and consumption, which raises aggregate demand. Businesses pay less to borrow money
as interest rates drop. This encourages businesses to increase their production capacity
and invest in new capital projects. Investment levels rise as a result.
(h) The government conducts contractionary monetary policy which involves lowering
the money supply and raising interest rates. The LM curve moves upward in response to
this shift, which raises the equilibrium interest rate. As a result, the actual interest rate
increases. Investment spending first decreases as borrowing gets more expensive in
response to changes in the money supply or an increase in interest rates. Consequently,
the overall demand is decreasing. As a result, the total output decreases along with the
equilibrium production level. People are frequently discouraged from taking out personal
loans by higher interest rates. As a result, consumer spending decreases. This decrease in
consumption leads to a decline in aggregate demand, which in turn affects overall output.
Contractionary monetary policy affects interest rates, which in turn affects investment.
An increase in interest rates results in higher borrowing costs, which discourages
investment. Investment levels therefore decline as monetary policy is contractionary.
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 relationship between the price and the real GDP that consumers, businesses, and the
government demand is represented by the aggregate demand (AD) curve. It is predicated
on actual GDP. Real GDP (Y) comprises three
components: Consumption(C), Investment (I), and Public Spending (G).
Y=C+I+G
(a) People change their behavior reduce their consumption and save more. The AD curve
is skewed to the left due to this decrease in consumption. A decrease in the necessary real
GDP quantity is indicated by the shift to the left. Stated differently, real family wealth
decreases in direct proportion to current or projected rising prices. As a result, savings
increase, and consumption decreases. Less supply would arise from this, increasing the
likelihood of unemployment.
(b) Business associations see the status of the economy negatively. This causes the AD
curve to shift to the left. This demonstrates how the flexibility of currency rates has led to
a decline in real GDP as a result of declining investment spending. This would result in
less supply, raising the possibility of unemployment.
(c) The government fosters an environment that encourages investment. This will result in
more output and a rise in real GDP since currency rates are flexible. The AD curve will
shift to the right as a result of this modification, showing a rise in real GDP. There would
be more jobs as a result of the increased supply.
(d) The government decreases its spending on education. This decline would cause the
AD curve to shift to the left. The AS curve is shifting to the left due to rising
manufacturing costs and the flexibility of currency rates. Then, the equilibrium would
shift, showing a gain in output, a decrease in price level, and an increase in
unemployment.
(e) The government implements an expansive fiscal strategy. This policy will improve
real GDP through more government expenditure, investment, and consumption. This will
cause the AD curve to shift to the right. Thus, the rate of unemployment.
(f) A contractionary fiscal policy is put into place to reduce inflation. As a result, the
economy's overall demand declines, shifting the AD curve to the left. A contractionary
fiscal policy raises unemployment, decreases overall output, and lowers price levels.
(g) Monetary expansion is implemented by the government. The AD curve will move to
the right when interest rates decline because more investment will be encouraged by
them. The real interest rate will drop as a result of flexible currency rates, which will lead
to capital inflows and outflows from the nation. Thus, putting such a plan into action
would increase equilibrium output, lower unemployment, and raise the price level.
(h) Contractionary monetary policy is implemented by the government. When interest
rates rise as a result of a decline in investment, the AD curve will move to the left.
Implementing such a scheme would therefore lead to decreased equilibrium output, a
lower price level, and more unemployment.
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
(a) People change their behavior reduce their consumption and save more. There will
be a decline and a leftward shift in the IS curve. Consequently, the amount of net
exports would increase while the amount of imports would fall. Until it is moved, the
IS will keep moving to the right. Capital will move from its current location to a new
one as a result of it. Because exchange rates are so erratic, a drop in one will lead the
value of the currency in the home economy to drop precipitously as well. When the
exchange rate drops, people save more and spend less, which lowers consumption.
Initially, output may decrease, but it may later rise if bigger savings spur greater
investment.
(b) Business firms are pessimistic about future economic perspectives; The IS is going
to contract and move to the left. When the real interest rate declines, capital will flow
from the origin to other areas. As a result, the value of net exports would rise and the
value of imports would decrease. The IS will move to the right again until it is moved.
Because exchange rates are so erratic, a drop in one will lead the value of the currency
in the home economy to drop precipitously as well. A small open economy with
unlimited capital mobility and a flexible exchange rate system may see a reduction in
investment, a devaluation of the local currency, a decline in GDP, a decline in
consumption, and a decline in overall business pessimism.
(c) The government provides a more attractive investment environment. The IS will
rise and shift to the right. The country of origin will attract foreign capital if the real
interest rate rises. The flexibility of exchange rates will lead to an increase in the
value of the currency used in the local economy as well as the exchange rate. As a
result, imports will increase and exports will decrease due to appreciation, resulting in
negative net exports. Until it reaches its starting point again, the IS will continue to
travel to the left. Overall, in the short run, these changes can lead to a mix of effects
on the economy including appreciation of the exchange rate, potentially higher GDP,
increased consumption, and higher investment levels.
(d) Government decreases its spending on education. As a result, the IS will shrink
and move to the left. Capital will shift from the origin to other regions as a result of
the real interest rate falling. The currency of the domestic economy will weaken.
Because exchange rates fluctuate, the value of the currency used in the domestic
economy will decrease as the exchange rate does. Consequently, imports would
depreciate and lose value while net exports would increase in value. Until it is moved,
the IS will move to the right once more. Overall, in the short run, a decrease in
government spending on education in a small open economy with free capital
mobility and a flexible exchange rate system can lead to a depreciation of the
domestic currency, mixed effects on total output, and a decrease in consumption.
(e) The government conducts expansionary fiscal policy, and the IS will grow and
shift to the right. The real interest rate will rise, which will attract capital to the
country of origin. in light of the currency rates' flexibility. The local economy's
currency will increase. Due to the flexibility of exchange rates, both the exchange rate
and the value of the currency used in the home economy will rise. Consequently,
imports will increase and exports will decrease due to appreciation, resulting in a
negative value for net exports. The IS will continue to travel left till it reaches its
starting position once more. The exchange rate, an increase in total output (GDP),
higher consumption levels, and increased investment.
(f) Government conducts contractionary fiscal policy. The IS will shift left and
plummet. There will be a decrease in the real interest rate, which will cause capital to
leave the country and go elsewhere. Because exchange rates are pliable, the value of
the currency in the home economy will decrease as a result of the exchange rate
falling. Because of this, net exports will increase in value while imports will decrease
due to depreciation. Until it is put back in its proper place, the IS will move to the
right once more. The economy's exchange rate is declining, and total output,
consumption, and investment levels are likely to decrease.
(g) Government conducts expansionary monetary policy. The LM will rise and move
to the right as a result. The real interest rate decreases, capital will start to flow in and
out of the country. Due to the flexibility of exchange rates, a drop in one will also
cause the value of the currency in the home economy to plummet. Consequently,
imports would depreciate and lose value while net exports would increase in value.
Once again, the IS will move to the right. High-income levels will cause the IS curve
to move to the right due to currency rate depreciation, which will increase total
production. In the particular economy, consumption and investment will both
increase.
(h) Government conducts contractionary monetary policy. The LM will descend and
shift to the left. The country of origin will attract foreign capital if the real interest rate
rises. The flexibility of exchange rates will lead to an increase in the value of the
currency used in the local economy as well as the exchange rate. As a result, imports
will increase and exports will decrease due to appreciation, resulting in negative net
exports. Once more, the IS will shift to the left. A move to the left in the IS curve due
to low income and rising exchange rates will result in a decrease in overall
production. Decrease total output (GDP), reduce consumption, and lower the level of
investment in the short run.
 (i) The government imposes a tariff on imported goods. The IS will rise and shift to
the right. The country of origin will attract foreign capital if the real interest rate rises.
The home economy's currency will appreciate because exchange rates shift. As a
result, imports will increase and exports will decrease due to appreciation, resulting in
negative net exports. Until it reaches its starting point again, the IS will continue to
travel to the left. Decrease total output (GDP), reduce consumption, and decrease the
level of investment.
(j) More domestic residents prefer to consume foreign goods. If net exports fall, the
economy will have an excess supply of goods. The IS curve will move to the left and
then start to decline. Money will flow from home markets to overseas ones as the real
interest rate declines. Due to the volatility of exchange rates, a decline in one will
cause the value of the currency in the domestic economy to plummet sharply. As a
result, net export volume would rise while import volume would decrease. In the
given economy, total output, consumption, and investment will all be equal.
(k) More foreigners prefer to consume domestic goods. This will cause the IS to
increase and shift to the right. The flexibility of exchange rates will lead to an increase
in the value of the currency used in the local economy as well as the exchange rate. As
a result, imports will increase and exports will decrease due to appreciation, resulting
in negative net exports. Until it reaches its starting point again, the IS will continue to
travel to the left. The exchange rate strengthens. Total output (GDP) increases,
Consumption levels rise, and Investment levels may also increase due to higher
profitability and increased demand.
b. the fixed exchange rate system.
(Suggest: Use Mundell-Fleming model)
(a) People change their behavior and reduce their consumption and save more, the
economy's level of investment and consumption falls, moving the IS curve to the left.
As the IS curve shifts to the left, interest rates will decrease. To protect the value of the
nation's currency, the central bank will reduce the amount of money in circulation until
the LM curve swings to the left. Overall output declines, investment may rise, and
consumption declines.
(b) Companies have low confidence in their capacity to make profits in the future or are
gloomy about the state of the economy. The IS curve will therefore shift to the left,
reducing the total production of the economy. As a result, the IS curve will move to the
left, lowering the economy's overall production. The economy's rate of exchange,
investment, consumption, and overall production are all lowered by this leftward shift in
the IS and LM curves. Pessimism among business firms can lead to a decrease in
investment, a decrease in consumption and investment.
(c) The government provides a more attractive investment environment. Investment will
increase as a result, and the IC curve will shift to the right. Interest rates will climb
above the world average due to a shift, which will draw money into the economy.
Capital inflows will increase the demand for local currency on the international market,
which will raise exchange rates. Lower interest rates encourage greater investment in
the economy. Higher total output, increased consumption, and higher investment levels.
(d) Government expenditure on education is cut. The IS curve will shift to the left in
response to a decrease in government investment in any sector. The IS curve's shift to
the left will result in lower interest rates. A decrease in domestic interest rates will
encourage domestic investors to make foreign investments, leading to a flight of capital.
The value of the home currency declines as a result, as does the exchange rate. Even if
the exchange rates are fixed, the central bank will nevertheless reduce the money supply
to reflect the decline in the demand for money. When the central bank reduces the
money supply, less money is available for domestic market transactions, which
consequently reduces consumer spending throughout the economy. Reduced
government spending on education may result in poorer overall output, a decline in the
value of the national currency, possibly decreased consumption, and unclear impacts on
investment.
(e) The government conducts expansionary fiscal policy, and the IS curve will shift to
the right. As a result, local interest rates are greater than those of the entire world. An
expansionary fiscal policy increases investment, national output, and consumption.
(f) The government implements a fiscally contractionary policy. Tax hikes and spending
cuts are two options available to the government for a contractionary budgetary plan. In
both scenarios, the interest rate will decrease and the IS curve will shift to the left. A
capital flight will occur as a result of lower interest rates, which will entice domestic
investors to transfer their funds to international markets. As a result, demand for foreign
currency will rise more than that of local currency. The exchange rate will decline as a
result. Therefore, reduced levels of investment, consumption, and national output will
result from contractionary government policies.
(g) Government conducts expansionary monetary policy does not affect an economy
that is subject to a fixed exchange rate regime. When the money supply is increased by
the central bank, the LM curve will shift to the right. A shift to the right causes interest
rates to drop below the level of the global interest rate. Local investors will make
investments in the foreign market. The currency rate must maintain a specific level as
mandated by the central bank. Consequently, the money supply is decreased by the
central bank until it reaches its initial level. The central bank will remove the excess
money it added to the market to bring the exchange rate back to its starting point. Total
Output, consumption and investment increase.
(h) A contractionary monetary policy by the government will lead the LM curve to
move to the left. Interest rates will not remain at their starting point. The value and
exchange rate of the currency will rise as a result of the central bank's reduction in
supply and the rising demand for local currency. As a result, neither investment nor
consumption nor the volume of the country's output will alter.
(i) The government imposes tariffs on imported goods, the number of imports entering
the economy will decline. A decline in imports will increase net exports. This will cause
the IS curve to shift to the right. An increase in interest rates brought about by a shift to
the right will stimulate capital inflows into the economy. The value of the exchange rate
increases in direct proportion to the value growth of the native currency. Raising the
import tariff will thereby decrease national output, investment, and consumption.
(j) More domestic residents prefer to consume foreign goods. The economy will import
more goods. This will lead to a decrease in net exports. When net exports fall, the IS
curve will move to the left. The exchange rate will return to its initial value when the
money supply shrinks and interest rates stabilize globally. In the end, this will mean that
interest rates are recovered and the exchange rate stays constant. However, the value of
the nation's output, investment, and consumption will all decline.
 (k) More foreigners prefer to consume domestic goods. Economic imports will increase.
This will lead to a decrease in net exports. When net exports fall, the IS curve will move
to the left. Interest rates will fall as a result of the shift as capital begins to leave the
market. As demand for foreign cash rises, the value of the native currency declines, and
the exchange rate drops. This will ultimately imply that interest rates are regained and
the currency rate remains unchanged. Nonetheless, investment, consumption, and the
country's output will all increase.
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
(a) When people alter their spending patterns and increase their savings, the real interest
rate decreases. The decreased interest rate causes a decrease in the demand for local
currency, which in turn lowers the exchange rate's value. Lower borrowing costs
stimulate investment, which raises output as a whole. Furthermore, as domestic goods
become more affordable for customers overseas, the currency's depreciation promotes
net exports, which raises output even further. Consumption may initially decline as
people save more and spend less. Nevertheless, if net export and investment growth,
together with increases in overall output and income, surpass the rate of fall in
consumption, consumption may eventually rise. Reduced interest rates promote
investment because they make loans to companies more accessible.
(b) Business firms are pessimistic about future economic perspectives. The production
and real interest rate would consequently decline as a result of the IS curve shifting to
the left. In a system with a flexible exchange rate, the interest rate changes to bring the
money market back into balance when the central bank does not step in to maintain a
certain exchange rate. Future consumption and investment would cause the economy's
overall production to decline. The IS curve would move to the left in response to this
modification, showing reduced output levels for each interest rate. A decline in
household consumption could be the consequence of a decline in consumer confidence
brought on by pessimism about future economic prospects. As was previously said, the
pessimism of corporate enterprises would result in a decrease in investment because
they would have lowered expectations regarding future profitability. As a result of the
lower investment, capital accumulation and economic growth would decline.
(c) The government provides a more attractive investment environment, and demand for
investments is likely to increase. The demand for loanable money will rise as a result,
increasing the actual interest rate. A greater aggregate demand generated by investment
will result in higher output. Companies intend to boost their output to fulfill the growing
demand for their goods and services. Higher output and earnings from increasing output
and investment should lead to increased consumer confidence and expenditure, which
will enhance consumption. The government's more hospitable investment climate will
lead to an increase in investment.
(d) The IS curve would move to the left if government spending on education were to
decline because this would lower total production and income, which would lower
demand for loanable funds. The real interest rate falls as a result of this. Since education
investment is a component of expenditure, which raises aggregate demand, a reduction
in government spending on education lowers overall production. The net effect is a
reduction in overall production. When total output declines, there is a corresponding
decrease in income and general economic activity, which leads to a reduction in both
consumption and investment.
(e) The fiscal expansion boosts demand overall, which raises interest rates since people
are more inclined to invest. Higher interest rates, however, draw capital inflows and
boost the value of the currency of the country. Consequently, the central bank might
step in, expand the money supply, divest the national currency, and bring interest rates
back to their previous levels. Total output rises as a result of the fiscal expansion's
increased aggregate demand. Lower borrowing rates and higher overall production lead
to increases in both investment and consumption.
(f) The contractionary fiscal policy's initial reduction of aggregate demand, which
simultaneously lowers investment demand, the real interest rate to fall. A drop in the
real interest rate encourages spending and investment, which raises total output. With
the real interest rate falling and overall output rising as a result, both investment and
consumption levels rose.
(g) An expansionary monetary policy lowers the domestic interest rate under the
flexible exchange rate system. Falling interest rates encourage capital flight, which
prevents investors from buying domestic assets, which lowers the value of the national
currency. A falling currency raises the cost of imports and lowers the price of exports,
increasing net exports and total output. Reduced interest rates encourage consumption
and investment, both of which raise total output.
(h) The Government conducts contractionary monetary policy, such as raising interest
rates or reducing the money supply, boosts domestic interest rates in a system with a
flexible exchange rate. The currency rate rises as a result of the influx of foreign
currency. The IS curve shifts to the left when net exports decline as a result of the
domestic currency's increase. The LM curve shifts to the left as a result of falling
investment and consumption due to rising interest rates. As a result, there is a general
decline as well as a decline in investment and consumption.
(i) The government imposes tariffs on imported goods causing net exports to decline,
which would increase interest rates and shrink the market for local currency. As a result,
the real interest rate can increase. The economy may see a decline in production and
overall output if net exports are reduced. A general decline in overall output and the
possibility of an increase in real interest rates could lead to a decline in both
consumption and investment levels.
(j) More domestic residents who prefer to consume foreign goods will rise as a result of
a greater demand for foreign currency to pay for imported goods, which will cause the
value of the home currency to decline. Higher imports and less domestic demand for
products and services could cause it to decline. If customers begin purchasing foreign
items, it might rise; however, this is contingent upon the impacts of substitution and
income. It can decline as a result of decreased domestic demand and exchange rate
uncertainty.
(k) As the demand for domestic currency increases and the value of the currency grows,
more foreigners are choosing to purchase domestic goods. Net exports consequently
decrease, increasing the availability of local assets. As a result, the actual interest rate
increases. An increase in the real interest rate deters investment, which reduces output
as a whole. A drop in total output is followed by drops in investment and consumption.
 b. the fixed exchange rate system.
(Suggest: Use IS-LM-BP model)
(a) People change their behavior reduce their consumption and save more. In the
domestic market, interest rates first go down as savings rise. The central bank will
intervene, acquiring local currency, increasing the money supply, and changing the LM
curve to maintain the exchange rate at its current level. This would counteract the actual
interest rate's initial drop. The central bank's move to maintain a stable exchange rate may
have offset the increase in investment and net exports that would have come from a
decline in the real interest rate. This implies that the impact on total output might be less
pronounced than under the flexible exchange rate regime. Like the variable exchange rate
system, higher savings at first could lead to lower consumption. Lower interest rates may
initially lead to an increase in investment.
(b) Business organizations have a negative outlook on the state of the economy. If
pessimism leads to a drop in investment and output, interest rates may come under
pressure. If the central bank had to intervene to maintain the fixed exchange rate, interest
rates would rise and reserves would fall. Like the variable exchange rate system,
pessimism would lead to a decline in output due to lower levels of investment and future
demand. The central bank's involvement in maintaining the fixed exchange rate, however,
may be able to partially offset the drop in output by altering monetary policy to increase
aggregate demand.
(c) The government provides a more attractive investment environment. The demand for
investments would rise, pushing interest rates higher. On the other hand, the central bank
would probably step in to stop the currency from strengthening under a fixed exchange
rate system. This may mean selling off local currency holdings, which increases the
money supply and drives down interest rates. Similar to the flexible exchange rate
regime, at first, the rise in investment would encourage an expansion in output. However,
if the central bank intervenes and lowers interest rates, this might also promote net
exports and consumer spending, which would boost output even further. Increased output
is anticipated to boost spending, as is the possibility of lower interest rates, which would
lower the cost of borrowing for consumers. Investment will increase as a result of the
government's more inviting investment environment.
(d) A reduction in government education investment would cause the IS curve to move to
the left, lowering overall output and income. On the other hand, under a fixed exchange
rate regime, the central bank would have to intervene to preserve exchange rate stability,
which would mean reducing the money supply and counteracting the decline in
government spending. The real interest rate would rise when the LM curve shifted to the
left. This would lead to a decrease in overall output because of less investment and higher
real interest rates. Investment and consumption drop as a result of lower income levels
and overall economic activity, which is exacerbated by rising real interest rates.
(e) The government's expansionary fiscal policy causes interest rates to rise. Conversely,
in the event of a fixed exchange rate, the exchange rate must be upheld by the central
bank. This could have negative effects on the money supply, raise interest rates, and force
people to sell their foreign reserves to pay for local currency. Total output rises as a result
of the fiscal expansion's increased aggregate demand. Initially, more investment and
consumption could be the outcome of a higher overall output.
(f) The real interest rate drops as a result of the contractionary fiscal policy's initial
reduction of aggregate demand, which also lowers investment demand. A decline in the
real interest rate stimulates investment and consumption, increasing output overall.
Investment and consumption increased as a result of the real interest rate declining and
the subsequent increase in overall output.
(g) An expansionary monetary policy reduces the domestic interest rate by increasing the
money supply in a system with a fixed exchange rate. The central bank must buy local
currency and sell foreign reserves to keep the fixed exchange rate and participate in the
foreign exchange market. By reducing the money supply, this intervention balances the
initial interest rate increase and prevents the domestic interest rate from falling too much.
Consequently, in comparison to the flexible exchange rate system, the effect on overall
output, consumption, and investment levels is less noticeable.
(h) The contractionary monetary policy drives up the interest rate domestically and draws
in capital from abroad. The central bank must step in and increase the money supply by
purchasing local currency and selling foreign reserves to preserve the fixed exchange
rate. The contractionary policy's initial effects are lessened by this intervention, which
lowers the rise in the domestic interest rate compared to what would happen in a system
with a flexible exchange rate. Consequently, the effects on total output, consumption, and
investment are less pronounced than they would be under a flexible exchange rate system.
(i) The government imposes a tariff on imported goods. The central bank may intervene
in a system with a fixed exchange rate to maintain stability, which would lower foreign
reserves. This could lead to a decrease in the money supply and an increase in the real
interest rate. In line with the flexible exchange rate system, a decline in net exports could
lead to a decline in overall output. The overall contraction in output as well as the
possible rise in real interest rates could lead to a decrease in both investment and
consumption levels.
(j) More domestic residents prefer to consume foreign goods. It might diminish as a result
of increased imports and decreased domestic demand. Any initial increase brought on by
the availability of less expensive imports could be offset by lower local income. It could
fall as a result of decreased local demand and skepticism about the fixed exchange rate's
long-term sustainability.
(k) More overseas consumers prefer to purchase native goods. When more international
consumers pick domestic goods, the central bank is forced to sell local currency to
maintain the fixed exchange rate. The money supply grows as a result, and the real
interest rate decreases. The current decline in real interest rates promotes investment and
increases total output. An increase in total output is accompanied by increases in
investment and consumption.