NATIONAL UNIVERSITY OF SINGAPORE Department of Economics EC3102 Macroeconomic Analysis II Questions and answers prepared by Ho Kong Weng Tutorial 9 Question 1 Consider an open economy with flexible exchange rates. Let UIP stands for the uncovered interest parity condition. (a) In an IS-LM-UIP diagram, show the effect of an increase in foreign output, Y*, on domestic output, Y. Explain in words. Answer: As Y* increases, net exports increase and the IS curve shifts to the right. Domestic output Y increases. From the UIP diagram, we note that the exchange rate appreciates as domestic interest rate goes up along the interest parity line. Note: We assume i* is held constant here. Basically, we do not ask why Y* changes here. (b) In an IS-LM-UIP diagram, show the effect of an increase in the foreign interest rate, i*, on domestic output, Y. Explain in words. Answer: The IS curve shifts right, because the increase in i* tends to create a depreciation of the domestic currency and therefore an increase in net exports, assuming the Marshall-Lerner condition holds. Domestic output increases. The interest parity line also shifts up. Note: We assume Y* is held constant here. Basically, we do not ask why i* changes here. Important note: Recall in the i-E space, i = i* when E = Ee, and the interest parity line will shift up (down) as i* increases (decreases). Similarly, the interest parity line will shift right (left) as Ee increases (decreases). Point to ponder: Will the slope of the interest parity line change as a result? Plotted in the i-E space, what is the vertical intercept of the UIP curve? (c) How would a foreign fiscal expansion affect Y* and i*? How would a foreign monetary expansion affect Y* and i*? Answer: A foreign fiscal expansion is likely to increase Y* and to increase i*. A foreign monetary expansion is likely to increase Y* and to reduce i*. Draw a simple IS-LM diagram in the i*-Y* space.

(d) Based in your results above, how does a foreign fiscal expansion affect domestic output Y? How about foreign monetary expansion? Answer: A foreign fiscal expansion is likely to increase home output. A foreign monetary expansion has an ambiguous effect on home output. The increase in Y* tends to increase home output, but the fall in i* tends to reduce home output.

Question 2 Consider a group of follower countries pegging their currencies to the currency of the leader country. Assume that the leader country can conduct monetary policies as it wishes. Suppose the domestic country is a follower country and the foreign country is the leader country for this tutorial question. (a) In a suitable diagram, show the effect of an increase in foreign output, Y*, on domestic output, Y. Explain in words. (b) In a suitable diagram, show the effect of an increase in the foreign interest rate, i*, on domestic output, Y. Explain in words. (c) Assume that a foreign fiscal expansion is likely to increase Y* and to increase i*, while a foreign monetary expansion is likely to increase Y* and to reduce i*. Together with your results above, explain how a foreign fiscal expansion and a foreign monetary expansion may respectively affect domestic output Y. (For the case of fiscal expansion in the foreign country, assume that the effect of Y* on domestic output Y is small.) Question 3 An economy suffers from a fall in business confidence which tends to reduce investment. Note: UIP stands for uncovered interest parity condition. (a) Suppose it has a flexible exchange rate. In an IS-LM-UIP diagram, show the short-run effect of a fall in business confidence on output, the interest rate, and the exchange rate. How does the change in the exchange rate, by itself, tend to affect output? Does the change in the exchange rate dampen or amplify the effect of the fall in business confidence on output? (b) Suppose, instead, it has a fixed exchange rate. In an IS-LM-UIP diagram, show how the economy responds to the fall in business confidence. What must happen to money supply in order to maintain the fixed exchange rate? Compare the effect on output with your answer in part (a). (c) Explain how the exchange rate acts as an automatic stabilizer in an economy with flexible exchange rates.