Balance of Payments I: Output,

18
Exchange Rates, and Macroeconomic
Policies in the Short Run

1. In 2001, President George W. Bush and Federal Reserve Chairman Alan Greenspan
were both concerned about a sluggish U.S. economy. They also were concerned about
the large U.S. current account deficit. To help stimulate the economy, President Bush
proposed a tax cut, whereas the Fed had been increasing U.S. money supply. Compare
the effects of these two policies in terms of their implications for the current account.
If policy makers are concerned about the current account deficit, discuss whether
stimulatory fiscal policy or monetary policy makes more sense in this case. Then, re-
consider similar issues for 2009–2010, when the economy was in a deep slump, the
Fed had taken interest rates to zero, and the Obama administration was arguing for
larger fiscal stimulus.
Answer: From the model, we know that fiscal expansion leads to crowding out of
investment and external demand because it leads to an appreciation in the home cur-
rency. In contrast, a monetary expansion leads to a decrease in the interest rate and a
depreciation in the currency, causing an improvement in the current account. There-
fore, if policy makers are concerned about reducing the current account deficit and
want to expand output, they should use monetary policy. These changes are summa-
rized in the following figure.

S-169
S-170 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies

Fiscal expansion

i ER
LM1

B B
i2 i2 DR2

A A
i1 i1 DR1

IS2

IS1 FR1

Y1 Y2 Y E2 E1 E$/F

Monetary expansion

i ER
LM1

LM2
A A
i1 i1 DR1

B B
i2 i2 DR2

IS1 FR1

Y1 Y2 Y E2 E1 E$/F

The situation in 2009–2010 was very different. The Fed had exhausted its monetary
toolkit. Keeping their interest rate target at zero meant the economy was at the zero
lower bound (in a liquidity trap). Under these circumstances, the job of reviving the
economy falls to fiscal policy. As of mid-December, 2010, a tax bill was being con-
sidered by Congress. If the current version of the bill is passed, there will be some ad-
ditional stimulus from the two-percentage-point reduction in the payroll tax for a
year, the two-year extension of the Bush tax cuts, and an extension of unemployment
compensation benefits. However, these are all temporary measures. We should not ex-
pect this bill to have the same punch as permanent changes in taxes. And, because of
the deep recession, the U.S. current account deficit for 2009 was about half its 2005
level. Under these circumstances, the United States (and most other countries) did not
pay much attention to the current account. They were properly concerned with re-
viving their domestic economies.
 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies S-171

2. Suppose that American firms become more optimistic and decide to increase invest-
ment expenditure today in new factories and office space.
a. How will this increase in investment affect output, interest rates, and the current
account?
Answer: This is an exogenous increase in investment demand. This leads to an
increase in the demand for goods, shifting the IS curve to the right. This leads to
an increase in output and the interest rate. The increase in the interest rate im-
plies an appreciation in the Home currency that decreases the current account.
This is illustrated in the following figure.

Exogenous increase in investment demand

D
D Y
D2

B
D1

IS1

Y1 Y2 Y

i ER
LM1

B B
i2 i2 DR2

A A
i1 i1 DR1

IS2

IS1 FR1

Y1 Y2 Y E2 E1 EH/F
S-172 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies

b. Now assume that domestic investment is very responsive to the interest rate so
that U.S. firms will cancel their new investment plans if the interest rate rises.
How will this affect the answer you gave previously?
Answer: If investment is very responsive to the interest rate, then this implies
that when interest rates rise, investment will decrease by a larger amount. For any
given change in the interest rate, investment will change by a larger amount, im-
plying the IS curve is flatter. Therefore, for a given exogenous increase in invest-
ment demand, the effect on output will be smaller. This is illustrated in the fol-
lowing diagram. The original shift in the IS curve shown in (a) is the dotted line.
Note that the horizontal shift in the IS curve is the same—this is the exogenous
increase. However, the effects on output, interest rates, and the current account
are smaller compared with (a).

Exogenous increase in investment demand

when investment demand is interest elastic
(more sensitive to change in interest rates)

D
D Y

D2
D1
B
i2

i1
A

IS1

Y1 Y2 Y

i ER
LM1

B B
i2 i2 DR2
A A
i1 i1 DR1
IS2

IS1

FR1

Y1 Y2 Y E2 E1 EH/F
 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies S-173

3. For each of the following situations, use the IS-LM-FX model to illustrate the effects
of the shock. For each case, state the effect of the shock on the following variables
(increase, decrease, no change, or ambiguous): Y, i, E, C, I, TB. Assume the govern-
ment allows the exchange rate to float and makes no policy response.
See the following figures.

Question 3a Question 3b

i LM1 ER i LM1 ER

B B
i2 i2 DR2
A A A A
i1 i1 DR1 i1 i1 DR1
B B
i2 i2 DR2 IS2
FR2

IS1 FR1 IS1 FR1

IS2
Y2 Y1 Y E1 E2 EH/F Y1 Y2 Y E1 E2 EH/F

Question 3c Question 3d

i LM1 ER i LM1 ER

B B
LM2 i2 i2 DR2
A A A A
i1 i1 DR1 i1 i1 DR1
B B
i2 i2 DR2 IS2

IS1 FR1 IS1 FR1

Y1 Y2 Y E1 E2 EH/F Y1 Y2 Y E1 E2 EH/F

a. Foreign output decreases.

Answer: IS shifts left, DR shifts down: Y ↓, i ↓, E ↑, C ↓, I ↑, TB ↑
b. Investors expect a depreciation of the Home currency.
Answer: FR shifts right, IS shifts right, DR shifts up: Y ↑, i ↑, E ↑, C ↑, I ↓,
TB ↑.
c. The money supply increases.
Answer: LM shifts right: Y ↑, i ↓, E ↑, C ↑, I ↑, TB ↑.
d. Government spending increases.
Answer: IS shifts right, DR shifts up: Y ↑, i ↑, E ↓, C ↑, I ↓, TB ↓
S-174 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies

4. How would a decrease in the money supply of Paraguay (currency unit is the
“guaraní”) affect its own output and its exchange rate with Brazil (currency unit is
the “real”). Do you think this policy in Paraguay might also affect output across the
border in Brazil? Explain.
Answer: A decrease in the real money supply leads to a leftward shift in the LM
curve. This leads to a decrease in Paraguay’s output, an increase in Paraguay’s interest
rates, and an appreciation in the guaraní.This is illustrated in the following figure.This
could affect output in Brazil through the trade balance. First, because Paraguay’s in-
come is lower, Brazil’s exports could decline. Second, because the real has depreciated
relative to the guaraní, this may make Brazilian exports more attractive to foreigners,
potentially boosting Brazil’s trade balance. The overall effects on Brazil’s trade balance
and its output are ambiguous.At the same time, Brazil’s economy is over 15 times the
size of Paraguay’s. Therefore, the impact of a change in Paraguay’s monetary policy on
Brazil’s economy is likely to be small. (Source: International Monetary Fund, World
Economic Outlook Database, October 2009. Data for both countries is included in
the Excel workbook for this chapter.)

LM2
i ER
LM1

B B
i2 i2 DR2

A A
i1 i1 DR1

IS1
FR1

Y2 Y1 Y E2 E1 EPar/Br
 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies S-175

5. For each of the following situations, use the IS-LM-FX model to illustrate the effects
of the shock and the policy response. (Note: Assume the government responds by us-
ing monetary policy to stabilize output.) For each case, state the effect of the shock on
the following variables (increase, decrease, no change, or ambiguous): Y, i, E, C, I, TB.
See the following diagrams. Point B is identical to the outcomes shown in Question 3.
Point C shows the outcome when monetary policy is used to stabilize output.

Question 5a Question 5b
LM3
i LM1 ER i C ER
LM1 C
i3 i3 DR3
LM3 B B
i2 i2 DR2
A A A A
i1 i1 DR1 i1 i1 DR1
B B
i2 i2 DR2 IS2
C C FR2
i3 i3 DR3
IS1 FR1 IS1
IS2 FR1
Y2 Y1 Y E1 E2 E3 EH/F Y1 Y2 Y E3 E1 E2 EH/F

Question 5c Question 5d
LM2
i LM1 ER i C LM1 ER C
i3 i3 DR3
LM2 B B
i2 i2 DR2
A C
A C A A
i1 i1 DR1 i1 i1 DR1
B B
i2 i2 DR2
IS2

IS1 FR1 IS1 FR1

Y1 Y2 Y E1 E2 EH/F Y1 Y2 Y E3 E2 E1 EH/F

a. Foreign output decreases.

Answer: IS shifts left, LM shifts right to stabilize Y: Y no change, i ↓, E ↑, C no
change, I ↑, TB ↑
b. Investors expect a depreciation of the Home currency.
Answer: FR shifts right, IS shifts right, LM shifts left to stabilize Y: Y no change,
i ↑, E ↓, C no change, I ↓, TB ↓
c. The money supply increases.
Answer: LM shifts right, then LM shifts left to stabilize Y: No change in Y, i, E,
C, I, or TB
d. Government spending increases.
Answer: IS shifts right, LM shifts left to stabilize Y: Y no change, i ↑, E ↓, C no
change, I ↓, TB ↓
 S-176 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies

6. Repeat the previous question, assuming the government responds to maintain a fixed
exchange rate. In which case or cases will the government response be the same as in
the Question 6?
See the following diagrams. Point B is identical to the outcomes shown in Question 3.
Point C shows the outcome when monetary policy is used to fix the exchange rate.

Question 6a Question 6b
LM3
i LM1 ER i LM3 LM ER
1
C C
i3 i3 DR3
i2 B B DR2
i2
C A A C A A
i1 i1 DR1 i1 i1 DR1
B B
i2 i2 DR2 IS2
FR2

IS1 FR1 IS1 FR1

IS2
Y3 Y2 Y1 Y E1 E2 EH/F Y1 Y3 Y2 Y E1E2 EH/F

Question 6c Question 6d

i LM1 ER i LM1 ER

B LM2 B
LM2 i2 i2 DR2
A=C
A C A C A C
i1 i1 DR1 i1 i1 DR1
B B IS2
i2 i2 DR2 i3

IS1 FR1 IS1 FR1

Y1 Y2 Y E1 E2 EH/F Y1 Y2 Y3 Y E2 E1 EH/F

Answer: IS shifts left, LM shifts left to keep E fixed: Y ↓, i and E no change, C ↓,

I no change, TB ↑
Answer: FR shifts right, IS shifts right, LM shifts left to keep E fixed: Y ↑, i ↑, E no
change, C ↑, I ↓, TB ↓
Answer: LM shifts right, then LM shifts left to keep E fixed: No change in Y, i, E,
C, I, or TB
Answer: IS shifts right, LM shifts right to keep E fixed: Y ↑, i and E no change,
C ↑, I no change, TB ↓
 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies S-177

7. This question explores IS and FX equilibria in a numerical example.

a. The consumption function is C
1.5  0.75(Y  T ). What is the marginal
propensity to consume, MPC? What is the marginal propensity to save, MPS?
Answer: MPC
0.75, MPS
0.25
b. The trade balance is TB
5(1  [1 / E ])  0.25(Y  8). What is the marginal
propensity to consume foreign goods, MPCF? What is the marginal propensity to
consume home goods, MPCH?
Answer: MPCF
0.25, MPCH
MPC  MPCF
0.75  0.25
0.5
c. The investment function is I
2  10i. What is investment when the interest
rate i is equal to 0.10
10%?
Answer: I
2  10(0.10)
1
d. Assume government spending is G. Add up the four components of demand and
write down the expression for D.
Answer: D
C  I  G  TB
D
1.5  0.75(Y  T )  2  10i  G  5(1  [1 / E ])  0.25(Y  8)
D
10.5  0.5Y  0.75T  10i  G  5(1 / E )
e. Assume forex market equilibrium is given by i
([1 / E]  1)  0.10 where
the two Foreign return terms on the right are expected depreciation and the For-
eign interest rate. What is the foreign interest rate? What is the expected future
exchange rate?
Answer: i*
10% Ee
1 (this is the UIP condition)
8. Continuing the last question, and solving for the IS curve, obtain an expression for
Y in terms of i, G, and T (eliminate E ).
Answer: Solve the UIP condition for E:
1 / E
(i  0.9)
Plug this expression into the demand curve from (d):
D
10.5  0.5Y  0.75T  10i  G  5(i  0.9)
Note that at goods market equilibrium, D
Y:
Y
10.5  0.5Y  0.75T  10i  G  5i  4.5
Y
6  0.5Y  0.75T  15i  G
0.5Y
6  0.75T  15i  G
Y
12  1.5T  30i  2G
9. Assume that initially the IS curve is given by IS1: Y
12  1.5T  30i  2G, and
that the price level P is 1, and the LM curve is given by LM1: M
Y(1  i ). The
Home central bank uses the interest rate as its policy instrument. Initially, the Home
interest rate equals the Foreign interest rate of 10% or 0.1. Taxes and government
spending both equal 2. Call this case 1.
a. According to the IS1 curve, what is the level of output Y? Assume this is the de-
sired full employment level of output.
Answer: IS: Y
12  1.5(2)  30(0.1)  2(2)
10
b. According to the LM1 curve, at this level of output, what is the level of the Home
money supply?
Answer: LM: M
10(1  0.1)
9
c. Plot the IS1 and LM1 curves for case 1 on a chart. Label the axes and the equi-
librium values.
S-178 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies

Answer: See the following diagram.

d. Assume that forex market equilibrium is given by i
([1 / E]  1)  0.10 where
the two foreign return terms on the right are expected depreciation and the For-
Problem 9
25.00%

20.00%

15.00%

10.00%

5.00% IS
LM

0.00%
8 9 10 11 12 13 14
Y
eign interest rate. The expected future exchange rate is 1. What is today’s spot ex-
change rate?
Answer: i
10%:
0.10
([1 / E]  1)  0.10
E
1
e. There is now a Foreign demand shock, such that the IS curve shifts left by 1.5
units at all levels of the interest rate, and the new IS curve is given by IS2:
Y
10.5  1.5T  30i  2G. The government asks the central bank to stabi-
lize the economy at full employment. To stabilize and return output back to the
desired level, according to this new IS curve, by how much must the interest rate
be lowered from its initial level of 0.1? (Assume taxes and government spending
remain at 2.) Call this case 2.
Answer: Plug the desired value of output (Y
10) into the new IS curve to
find the implied interest rate, i2:
(10)
10.5  1.5(2)  30i  2(2)
10
11.5 30i
30i
1.5
i
0.05
5%
f. At the new lower interest rate and at full employment, on the new LM curve
(LM2), what is the new level of the money supply?
Answer: Plug the output and interest rate from (e) into the LM curve to find M:
M
10(1  0.05)
9.5
The money supply must increase from 9 to 9.5 to achieve the desired decrease
in the interest rate from 10% to 5%.
g. According to the forex market equilibrium, what is the new level of the spot ex-
change rate? How large is the depreciation of the home currency?
Answer: Plug the new interest rate into the UIP condition:
 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies S-179

Problem 9a
25.00%

20.00%

15.00%

10.00%
IS
LM
5.00% New IS
New LM

0.00%
8 9 10 11 12 13 14
Y

0.05
(1 / E  1)  0.10
0.05
1 / E  1
1 / E
0.95
E
1.053
The nominal exchange rate will increase from 1 to 1.053 when the money sup-
ply increases. The currency depreciates by 5.3% (
[1.053  1] / 1).
h. Plot the new IS2 and LM2 curves for case 2 on a chart. Label the axes, and the
equilibrium values.
Answer: See the left of the following diagram.

i i

15% 15%
LM2
LM1 LM1
A B
i1 10% i1 10% A C
LM2

B
i2 5% 5%
IS1 IS1
IS2 IS2

8 10 12 Y 8 8.5 10 12 Y
Y1 Y3 Y1
S-180 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies

i. Return to (e). Now assume that the central bank refuses to change the interest
rate from 10%. In this case, what is the new level of output? What is the money
supply? And if the government decides to use fiscal policy instead to stabilize
output, then, according to the new IS curve, by how much must government
spending be increased to achieve this goal? Call this case 3.
Answer: If the central bank wishes to keep i
i1
10%, then we can find the
implied level of output from the new IS curve:
Y
10.5  1.5(2)  30(0.10)  2(2)
8.5
From the LM curve we can find the money supply in this case:
M
8.5(1  0.10)
7.65
The money supply must decrease from 9 to 7.65 to keep the interest rate un-
changed.
If the government wants to stabilize output by adjusting government spending
(at a fixed interest rate of 10%), we can use the new IS curve to find the implied
value of G:
10
10.5  1.5(2)  30(0.10)  2G
G
2.75
Therefore, G must increase from 2 to 2.75 to offset the effects of the foreign de-
mand shock.
j. Plot the new IS3 and LM3 curves for case 3 on a chart. Label the axes and the
equilibrium values.
Answer: See the preceding figure to the right. Notice that once the government
increases spending, the central bank will increase the money supply from 7.65 to
9 as the interest rate rises with increase in government spending.
10. In this chapter, we’ve studied how policy responses affect economic variables in an
open economy. Consider each of the problems in policy design and implementation
discussed in this chapter. Compare and contrast each problem as it applies to mone-
tary policy stabilization versus fiscal policy stabilization.
Answer: Consider the following limitations:
• Policy constraints. Depending on the exchange rate regime, these are more likely
to restrict monetary policy. Because monetary policy typically uses a nominal an-
chor, such as a fixed exchange rate or interest rate, this will limit the ability of cen-
tral bankers to respond in accordance with its “rules.”
• Incomplete information and the inside lag. Fiscal policy is more likely to be restricted
by these problems. Fiscal policy faces institutional limitations in how fiscal policy is
decided upon, whereas monetary policy decisions are made by a small number of ex-
perts. Also, fiscal policy makers are less likely to have the expertise needed to gener-
ate or interpret economic forecasts of output and other key variables.
• Policy response and the outside lag. Monetary policy is more likely to suffer from
this problem because it works through interest rates. In the model, we assume
there is one interest rate, but in reality, the central bank influences short-term rates
in the hopes that this will affect the long-term rates that matter for investment.
• Long-horizon plans. This problem is likely to affect both fiscal and monetary pol-
icy. If households respond to tax cuts or increases in government spending ac-
cording to the long-run budget constraint, they know that tax cuts today mean
more taxes in the future. If they want to smooth consumption, then they should
save in response to the tax cut, leaving consumption, and hence the IS curve, un-
changed. Similarly, monetary policy works through interest rates, but if these
changes are not large enough in the short run, the effects on investment (usually
planned over long time horizons) may be limited.
 Solutions ■ Chapter 18 Output, Exchange Rates, and Macroeconomic Policies S-181

• Weak links from the nominal exchange rate to the real exchange rate, pegged cur-
rency blocs, and weak links from the real exchange rate to the trade balance. All
three of the limitations have implications for fiscal and monetary policy in much the
same way. Recall that changes in the trade balance and the exchange rate tend to
magnify the effects of a given monetary policy action while muting the effects of a
fiscal policy action in a floating exchange rate regime.Thus, if monetary policy mak-
ers rely on this channel, their ability to stabilize output will be less effective.