8. In a small open economy, net exports NX depend negatively on domestic in- come Y and negatively on the real exchange

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8 In A Small Open Economy Net Exports Nx Depend Negatively On Domestic In Come Y And Negatively On The Real Exchange 1 (266.94 KiB) Viewed 19 times

8. In a small open economy, net exports NX depend negatively on domestic in- come Y and negatively on the real exchange rate e = eP/P, where e is the nom- inal exchange rate (the foreign-currency price of domestic currency), and P and P are the domestic and foreign-currency prices of domestically and foreign- produced goods, respectively. Assume initially that both P and P are fixed. There is perfect mobility of capital, so balance of payments equilibrium requires that i = 1, where i and i are the domestic and foreign interest rates. Assume the economy adopts a flexible exchange rate regime. (a) [4 marks] Using the IS-LM-BP model, carefully explain whether monetary policy and/or fiscal policy can succeed in raising the economy's GDP. Now assume instead that the economy adopts a fixed exchange rate regime. (b) [4 marks] For each of the policies below, explain what foreign-exchange market intervention is required to support the fixed exchange rate, and whether the policy would succeed in raising GDP: i. Increasing the supply of money ii. Increasing government expenditure Suppose export markets are so important to domestic firms that they choose to fix the price of their goods in foreign currency, denoted by F. The domestic currency price P of domestic goods adjusts if necessary so that eP = F, with F remaining constant. Assume that P* is fixed as before. (c) [2 marks] Briefly explain why the results you have found in part (b) would be the same in this case. (d) [3 marks] With a flexible exchange rate regime, how does a depreciation of the domestic currency (lower e) affect the real exchange rate € = eP/P and the domestic price level P in this case? In the IS-LM-BP diagram, which curves would shift in which direction? Explain. (e) [5 marks] Using your answer to part (d), consider again the effectiveness of monetary and fiscal policy in raising GDP under a flexible exchange rate regime. Explain intuitively why your findings differ from those in part (a). (f) [2 marks] With reference to your answers to parts (c) and (e), summarize the implications of the different way in which prices of domestic goods are set in this case for the relative potency of monetary and fiscal policy and the choice of exchange rate regime.