P = λPd + (1-2) Pfle where Pd is the price of domestic goods, Pf is the price of foreign goods measured in the foreign currency, and e is the exchang rate. Thus, Ple is the price of foreign goods measured in the domestic currency. The parameter is the share of domestic goods in the price index P. Assume that the price of domestic goods Pa and the price of foreign goods measured in foreign currency are sticky in the short run. (Note: Since a higher exchange rate makes foreign goods cheaper, to the extent that people consume foreign goods (given by th fraction 1-2), the price level P that is relevant in the money market falls. The lower price level increases the supply of real money balances M/P. And to maintain equilibrium in the money market, income must rise, so money demand increases as well Hence, the LM curve is now upward sloping rather than vertical, as in the standard Mundell-Fleming model.) a. In the accompanying diagram, shift the IS curve, the LM curve, or both to show the effect of an expansionary fiscal policy under a floating exchange rate system. Exchange Rate, e LM IS

P = λPd + (1-2) Pfle where Pd is the price of domestic goods, Pf is the price of foreign goods measured in the foreign currency, and e is the exchang rate. Thus, Ple is the price of foreign goods measured in the domestic currency. The parameter is the share of domestic goods in the price index P. Assume that the price of domestic goods Pa and the price of foreign goods measured in foreign currency are sticky in the short run. (Note: Since a higher exchange rate makes foreign goods cheaper, to the extent that people consume foreign goods (given by th fraction 1-2), the price level P that is relevant in the money market falls. The lower price level increases the supply of real money balances M/P. And to maintain equilibrium in the money market, income must rise, so money demand increases as well Hence, the LM curve is now upward sloping rather than vertical, as in the standard Mundell-Fleming model.) a. In the accompanying diagram, shift the IS curve, the LM curve, or both to show the effect of an expansionary fiscal policy under a floating exchange rate system. Exchange Rate, e LM IS

ENGR.ECONOMIC ANALYSIS

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ISBN:9780190931919

Author:NEWNAN

Publisher:NEWNAN

Chapter1: Making Economics Decisions

Section: Chapter Questions

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Question

P = λPd + (1-2)Pƒle
where Pd is the price of domestic goods, Pfis the price of foreign goods measured in the foreign currency, and e is the exchange
rate. Thus, Pfle is the price of foreign goods measured in the domestic currency. The parameter is the share of domestic goods
in the price index P. Assume that the price of domestic goods Pa and the price of foreign goods measured in foreign currency Pf
are sticky in the short run.
(Note: Since a higher exchange rate makes foreign goods cheaper, to the extent that people consume foreign goods (given by the
fraction 1-2), the price level P that is relevant in the money market falls. The lower price level increases the supply of real
money balances M/P. And to maintain equilibrium in the money market, income must rise, so money demand increases as well.
Hence, the LM curve is now upward sloping rather than vertical, as in the standard Mundell-Fleming model.)
a. In the accompanying diagram, shift the IS curve, the LM curve, or both to show the effect of an expansionary fiscal policy
under a floating exchange rate system.
Exchange Rate, e
LM
IS

O Macmillan Learning
b. As a result of the fiscal expansion, the exchange rate
c. In the standard Mundell-Fleming model, as a result of a fiscal expansion, the exchange rate
aggregate income
Exchange Rate, e
and aggregate income
d. Suppose political instability increases the country risk premium and thus the interest rate. Again, assuming a floating
exchange rate system, in the accompanying diagram, shift the IS curve, the LM curve, or both to show the effect of this
development.
LM
IS
and

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