Queen's University at Kingston

Economics 222

Sections A and C

Assignment # 4

Fall 1998

Instructors: Lawrence McDonough; Ryan Davies

  1. (a) Explain the difference between the I and S curves in Investment-Savings Diagram and the IS diagram.

    (b) Show how the curve of the IS curve is related to the slope of the I curve.

    (c) What is the economic interpretation of a relatively flat I curve?

  2. (a) What information is being presented in an LM curve?

    (b) Recall the definition of a real interest rate. What is the effect on the LM curve of an increase in the expected inflation rate? Explain.

    (c) What does the price level have to do with the LM curve?

    (d) Suppose that the stock market runs into a period of large price variability in both stocks and bonds. Could this affect the LM curve? Explain.

  3. Show how the economy is affected by an increase in government expenditures. Explain the difference between the Classical and Keynesian analyses. (Assume a closed economy).

  4. (a) Explain the difference between the real and the nominal exchange rate.

    (b) Explain the "J-curve" effect of a decreased real exchange rate.

  5. Why do net exports change in response to real interest rate changes? Show how this is used to derive the open economy IS curve.

  6. Analyse the case of a monetary expansion to highlight the key difference between a fixed and a flexible exchange rate regime.


Answers:

  1. (a) The I and S curves show the desired investment and desired savings for different interest rates, holding all other variables constant. The interest rate at the intersection of the I and S curves is the equilibrium interest rate. If some shock affects either the I or S curve, there will be a new equilibrium interest rate and new equilibrium I=S.
    The IS curve is a set of many potential equilibrium points for the goods market. In particular, it shows the equilibrium interest rate that would occur in the I=S framework if we looked at different possible levels of real income, holding other variables fixed.
    (b) To show  how the slope of the IS is related to the slope of the I curve, note that in the I=S diagram, the S curve shifts right if Y increases (so savings increase). The flatter is the I curve, the less will be the fall in the interest rate. Thus a given change in income will require a smaller change in equilibrium interest rate for flatter I curves which means a flatter IS curve. (A diagram is worth many words).
    (c) The slope of the I curve represents the interest rate sensitivity of investment demand. Thus a flatter IS curve implies that demand in the economy is relatively interest rate sensitive. Investment demand is relatively sensitive to interest rate movements.

  2. (a) The LM curve is a set of many potential equilibrium points for the asset market. In particular, it shows the equilibrium interest rate that would occur in the Ms=Md framework if we looked at different possible levels of real income, holding other variables fixed.
    (b) real r = nominal r - expected inflation rate: Inflation reduces the real rate. Since nominal r on money is about 0, the real return is often negative. Rather than allow purchasing power be eroded by holding money with increased inflation, demand will shift to assets with positive and safer real rates of return (hedge against inflation - gold, durables).
    (c) As the price level increases, the real money supply falls. This is equivalent to a reduction in Ms with prices constant. The LM curve shifts to the left and the eqiulibrium interest rate rises for a given level of income. Alternatively, the reduced money supply implies there is an excess demand for cash balances which drives the price of money , r, up.
    (d) The increased volatility of financial asset prices signals an increased riskiness of these assets. This would cause a move to less risky assets such as money. Hence the demand for money is predicted to increase which increases the equilibrium rate of interest; the LM curve shifts left.

  3. Closed Economy Expansionary Fiscal Policy:

    A diagram helps: IS-LM-FE diagram
    - FE is not affected
    - Direct effect: If G rises then taxes must be raised at some time. In the long run, both C and S must fall because disposable income falls. A decrease in S shifts the IS up. (S moves left in the I and S equilibrium and r increases).
    - Short run equilibrium: IS-LM intersect at Y>Yfe and at higher r.
    - Long run equilibrium: Where Y>Yfe in short run, there is excess demand for goods which causes wages and prices to rise. The increased price level reduces real money supply and shifts the LM to the left until it intersects the new IS-FE intersection. In the long run there is no net effect on the level of output and employment.

    Classical and Keynesian analyses differ on their view of the length of the short run. For Keynesians, the short run is sufficiently long to make the increased output a valued benefit. A Classical analysis would suggest a faster adjustment in prices and wages so that there are at best small benefits from such policies.

  4. (a) The nominal exchange rate measures the value of a domestic unit of currency (the Canadian dollar) in terms of a foreign currency. For example, one $C is valued at $0.64US. The real exchange rate measures the value of a Canadian good (or unit of real GDP) in terms of units of a foreign good.

    e = enom P/Pfor

    enom = 0.63 ; Canadian good C$100, same US good US$70

    e = (0.63*100)/70 = 0.9

    The Canadian good can be traded for 0.9 units of the US good. (The value of Canadian good is traded for $US which is US$63. This buys 90% of the same good in the US market.)

    (b) In response to a decrease in the exchange rate, it is possible that imports and exports take some time to adjust. Imports become more expensive and substitutes must be found. Exports also take time to adjust. However, the decrease in the exchange rate means imports cost more and revenues for exports fall. In the short run when prices move more than quantities, the increased dollar value of imports and decreased dollar value of exports may cause the NX to fall.  When import and export quantities adjust, NX rises as predicted.

  5. Consider first the I and S relationship. Note that desired S-I is increasing as r increases. In an open economy S=I+NX or S-I=NX defines an equilibrium in the goods market. Now consider NX. An increase in r (rfor being held fixed) would induce capital inflows. This new demand for $C on international markets bides up the price of the $C; the exchange rate rises. However NX wil fall in response to the e rise. Thus NX is negatively related to the interest rate.
    Now start at an equilibrium: S-I=NX. Suppose Y increases. What happens to equilibrium r? The increase in Y causes S to increase; S-I shifts right. But imports also increase and NX is decreased. Both effects serve to reduce the interest rate. The higher Y will require a lower r for goods market equilibrium. (Note: Increased interest rates reduce demand for both I and NX so that demand is more interest sensitive under flexible rates than in a closed economy. This implies a relatively flatter IS curve.)

  6. Expansionary Monetary policy under fixed and flexible rates

    Flexible Rates:

    - No change to FE
    - Direct effect is to the shift LM right

    Short Run Equilibrium: IS-LM intersection to right of FE. Y increases, imports increase, NX falls, r decreases, capital outflows increase, NX rises. NX may rise or fall, but the Y and r effects both increase the supply of $C to the international markets and causes enom to fall (e falls too).

    Long Run Equilibrium: Y>Yfe causes P to rise and LM to shift (real Ms is falling) left until we return to the original equilibrium. The rise in P causes e to return to its original value, enom stays at it new lower level. Real Y is unchanged. (Money is neutral!)

    Fixed Rates:

    There are no effects running from r to NX because enom will be held fixed. As under flexible rates, the short run effect of increasing Y and decreasing r cannot occur - as soon as pressure mounts to reduce the exchange rate the monetary authorities must intervene to to keep it fixed. In this case the authorities have to reduce the supply of money. (The Bank of Canada intervenes by buying the excess supply of $C using foreign reserves. The $C are put in the Bank and this reduces the Ms in Canada.) A FE-IS-LM diagram or a FV-officail rate diagram could be useful in answering this question.

    Monetary policy cannot be used for domestic purposes under fixed exchange rates. It is used to fix the exchange rate. Under flexible rates monetary policy can have real effects in the short run (Classical and Keynesian schools disagree on the length of the short run) but money is neutral in the long run.
     
     

    END