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Homework answers / question archive / Open Economy IS-LM-FE model The behaviour of households and firms in an open economy is represented by the following equations: Desired consumption: cd = 350 +0
Open Economy IS-LM-FE model The behaviour of households and firms in an open economy is represented by the following equations: Desired consumption: cd = 350 +0.5Y – 200r Desired investment : id = 250 – 300r Net exports : NX = 0.05YF – 0.1Y - 0.5e Real money demand : Md = Y – 4000(r + ) ? where expected inflation is T = 0 and YF = 2000 denotes the income of foreign households. Government purchases are G=95 and the supply of money by M=480. Assume that international interest parity holds and that the economy is initially in a general equilibrium with a real exchange rate, e=90 and output Y=1200. Questions 9 to 18 relate to this information.
Question 11 (4 points) In the initial general equilibrium, what are the foreign real interest rate and the price level? P* = 2; f = 0.05 p* = 0.5;rf = 0.12 P* = 0.5; f = 0.06 P* = 2; rf = 0.06
The economy is defined as
Desired Consumption,
• Cd = 350 + 0.5.Y - 200.r
Desired Investment,
• Id = 250 - 300.r
Net Exports,
• NX = 0.05.YF - 0.1.Y - 0.5.e
• YF = 2000
Government Expenditure,
• G = 95
Real Money Demand,
• Md/P = Y - 4000.(r + πe)
• πe = 0
• M = 480
At equilibrum,
• Y = 1200 and e = 90.
Question 11
At equilibrum in the goods market (IS curve),
Y = Cd + Id + G + NX
or, Y = 350 + 0.5.Y - 200.r + 250 - 300.r + 95 + 0.05.YF - 0.1.Y - 0.5.e
or, Y = 695 + 0.4.Y + 0.05.YF - 0.5.e - 500.r
or, 0.6.Y = 695 + 0.05.YF - 0.5.e - 500.r
Putting, YF = 2000, Y = 1200, e = 90 we get,
0.6×1200 = 695 + 0.05×2000 - 0.5×90 - 500.r
or, 720 = 750 - 500.r
or, r = r??????F = 0.06
Both the home and foreign real interest rates are same.
The foreign real interest rate is r??????F = 0.06.
Now, at equilibrum in the money market (LM curve),
Md/P = Y - 4000.(r + πe)
Putting Md = M = 480, Y = 1200, πe = 0 and r = 0.06 we get,
480/P = 1200 - 4000×(0.06 + 0)
or, 480/P = 960
or, P* = 0.5
The price is P* = 0.5.
In the initial general equilibrum,
• The foreign real interest rate is r??????F = 0.06.
• The price level is P* = 0.5.
??????We eliminate options (a), (b) and (d) as these do not match our result.
Answer is option (c) i.e. P* = 0.5; r??????F = 0.06.