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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

Economics

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

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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.

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