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2. Consider a country operating under fixed exchange rates, with aggregate demand and aggregate supplygiven by equa- tions (21.1) and (21.2). AD:Y = Y AS:P = P(1 + m) F(1 - :) Assume that the economy is initially in medium-run equi- librium, with a constant price level and output equal to the naturallevel of output. Foreign output, the foreign price level, and the foreign interest rate are fixed throughout the problem. Assume that expected (domestic) inflation remains constant throughout the problem. a. Draw an AD-AS diagram for this economy. b. Now suppose there is an increase in government spend- ing. Show the effects on the AD-AS diagram in the short run and the medium run. How do output and the price level change in the medium run? c. What happens to consumption in the medium run? d. What happens to the real exchange rate in the medium run? (Hint: Consider the effect on the price level you iden- ti fied in part (b).] What happens to net exports in the me- dium run? e. Given that the exchange rate is fixed, what is the domestic nominal interest rate? Does the increase in government spending affect the domestic nominal interest rate? What happens to the real interest rate in the medium run? (Hint: Remember that expected inflation remains constant by as- sumption.) What happens to investment in the medium run? f. In a closed economy, how does an increase in government spending affect investment in the medium run? (Refer to Chapter 7 ifyou need a refresher.)

2. Consider a country operating under fixed exchange rates, with aggregate demand and aggregate supplygiven by equa- tions (21.1) and (21.2). AD:Y = Y AS:P = P(1 + m) F(1 - :) Assume that the economy is initially in medium-run equi- librium, with a constant price level and output equal to the naturallevel of output. Foreign output, the foreign price level, and the foreign interest rate are fixed throughout the problem. Assume that expected (domestic) inflation remains constant throughout the problem. a. Draw an AD-AS diagram for this economy. b. Now suppose there is an increase in government spend- ing. Show the effects on the AD-AS diagram in the short run and the medium run. How do output and the price level change in the medium run? c. What happens to consumption in the medium run? d. What happens to the real exchange rate in the medium run? (Hint: Consider the effect on the price level you iden- ti fied in part (b).] What happens to net exports in the me- dium run? e. Given that the exchange rate is fixed, what is the domestic nominal interest rate? Does the increase in government spending affect the domestic nominal interest rate? What happens to the real interest rate in the medium run? (Hint: Remember that expected inflation remains constant by as- sumption.) What happens to investment in the medium run? f. In a closed economy, how does an increase in government spending affect investment in the medium run? (Refer to Chapter 7 ifyou need a refresher.)

Brief Principles of Macroeconomics (MindTap Course List)
Brief Principles of Macroeconomics (MindTap Course List)
8th Edition
ISBN:9781337091985
Author:N. Gregory Mankiw
Publisher:N. Gregory Mankiw
Chapter13: Open-economy Macroeconomics: Basic Concepts
Section: Chapter Questions
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2. Consider a country operating under fixed exchange rates, with aggregate demand and aggregate supply given by equa- tions (21.1) and (21.2). AD: Y = Y AS:P = P(1 + m) F(1 - -) Assume that the economy is initially in medium-run equi- librium, with a constant price level and output equal to the naturallevel of output. Foreign output, the foreign price level, and the foreign interest rate are fixed throughout the problem. Assume that expected (domestic) inflation remains constant throughout the problem. a. Draw an AD-AS diagram for this economy. b. Now suppose there is an increase in government spend- ing. Show the effects on the AD-AS diagram in the short run and the medium run. How do output and the price level change in the medium run? c. What happens to consumption in the medium run? d. What happens to the real exchange rate in the medium run? [Hint: Consider the effect on the price level you iden- ti fied in part (b).] What happens to net exports in the me- dium run? e. Given that the exchange rate is fixed, what is the domestic nominal interest rate? Does the increase in government spending affect the domestic nominalinterest rate? What happens to the real interest rate in the medium run? (Hint: Remember that expected inflation remains constant by as- sumption.) What happens to investment in the medium run? f. In a closed economy, how does an increase in government spending affect investment in the medium run? (Refer to Chapter 7 ifyou need a refresher.)
Transcribed Image Text:2. Consider a country operating under fixed exchange rates, with aggregate demand and aggregate supply given by equa- tions (21.1) and (21.2). AD: Y = Y AS:P = P(1 + m) F(1 - -) Assume that the economy is initially in medium-run equi- librium, with a constant price level and output equal to the naturallevel of output. Foreign output, the foreign price level, and the foreign interest rate are fixed throughout the problem. Assume that expected (domestic) inflation remains constant throughout the problem. a. Draw an AD-AS diagram for this economy. b. Now suppose there is an increase in government spend- ing. Show the effects on the AD-AS diagram in the short run and the medium run. How do output and the price level change in the medium run? c. What happens to consumption in the medium run? d. What happens to the real exchange rate in the medium run? [Hint: Consider the effect on the price level you iden- ti fied in part (b).] What happens to net exports in the me- dium run? e. Given that the exchange rate is fixed, what is the domestic nominal interest rate? Does the increase in government spending affect the domestic nominalinterest rate? What happens to the real interest rate in the medium run? (Hint: Remember that expected inflation remains constant by as- sumption.) What happens to investment in the medium run? f. In a closed economy, how does an increase in government spending affect investment in the medium run? (Refer to Chapter 7 ifyou need a refresher.)
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