# An Open Economy Model of the Goods Market

ECON 305 Intermediate Macroeconomics: Assignment 6 Answers

QUESTION 1 – Openness in Goods and Financial Markets

a) Explain the three types of trade that countries conduct.

b) Define the nominal exchange rate of a country. Define the real exchange rate of a

country. Why is the real exchange rate the appropriate price for thinking about decisions

by consumers and firms about whether to buy domestic or foreign goods and services?

c) Explain how the nominal exchange rate, and domestic and foreign price inflation affect

the real exchange rate.

d) If the domestic country’s real exchange rate (currency) depreciates, how would you

expect this to affect the domestic country’s trade balance in goods and services? Explain.

e) What do we mean by purchasing power parity (a theory of real and nominal exchange

rates)? If the domestic country’s price level declines, what does purchasing power parity

predict would tend to happen to the nominal exchange rate and foreign price level?

Explain.

f) What is the source of large differences between the GDP and GNP of oil exporting

countries? In answering the question, explain carefully the difference between gross

domestic product and gross national product.

g) Suppose the uncovered interest parity condition holds, and that the domestic interest

rate is lower than the foreign interest rate. What does this imply about the current versus

future expected currency value for the domestic country?

h) Assume that the one-year interest rate in the United States is 4% and that the one-year

interest rate in Canada is 3%. According to uncovered interest rate parity, what does this

imply about the current versus the future expected value of the US dollar? Explain.

i) Explain why a simple comparison of the interest rates on domestic and foreign bonds

might provide misleading information about which bonds yield the highest expected

returns.

QUESTION 2 – An Open Economy Model of the Goods Market

a) Explain the difference between: (a) the demand for domestic goods; and (b) the domestic

demand for goods. In your answer, write down equations which describe (a) and (b).

b) Explain the determinants of (a) exports and (b) imports. Write an algebraic expression for

c) Explain why the demand for domestic goods curve (ZZ) has a different slope than the

domestic demand curve (DD).

d) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase

in taxes, T, will have on output, exports, imports, and net exports. Clearly label all curves and

clearly label the initial and final equilibria.

e) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase

in foreign output (Y*) will have on output, exports, imports, and net exports. Clearly label all

curves and clearly label the initial and final equilibria.

f) Explain why the multiplier for autonomous demand changes in an open economy is

different from the multiplier in a closed economy.

g) Explain the Marshall-Lerner condition. Assuming that the Marshall-Lerner condition

holds, and using the ZZ/Y and NX graphs, illustrate graphically and explain in words what

effect a real depreciation will have on output, exports, imports, and net exports. Clearly label

all curves and clearly label the initial and final equilibria.

h) Suppose a country is experiencing a situation where output is above the full employment

or natural level, and has a trade deficit. Further assume that the policy makers’ goals are to

achieve full employment output and balanced trade. Given this information, what type of

exchange rate and/or fiscal policy can be used to achieve simultaneously these two goals?

Explain your answer carefully.

i) Using the ZZ/Y and NX graphs, illustrate graphically and explain what effect an increase in

government spending will have on output, exports, imports, and net exports. Clearly label all

curves and clearly label the initial and final equilibria.

QUESTION 3 – An Open Economy Model of the Goods Market

Consider an open economy characterized by the following equations:

= 0 + 1 ( − )

= 0 + 1

= 1

= 1 ∗

The parameters 1 and 1 are the marginal propensities to import and export respectively.

Assume that the real exchange rate is fixed at a value of 1, and treat foreign income Y* as

fixed. Let taxes T be fixed, and G be determined exogenously by the domestic government.

a) Write the equilibrium condition in the market for domestic goods and solve for the

equilibrium value of Y.

b) Suppose government purchases, G, increase by one unit. What is the quantitative

effect on output? (Assume that 0 < 1 < 1 + 1 < 1 and explain why.)

c) What is the quantitative effect for net exports change when government purchases

increase by one unit?

Now let there be two economies, one with 1 = 0.5

economy is characterized by 1 + 1= 0.6.

and another with 1 = 0.1. Each

d) Suppose one of the economies is much larger than the other. Which economy do you

expect to have the larger value of 1 ? Explain.

e) Calculate your answers to b) and c) for each economy by substituting in the

appropriate parameter values.

f) In which economy will fiscal policy have a larger effect on output? In which economy

will fiscal policy have a larger effect on net exports? Explain your answers.

QUESTION 4 – Open Economy IS-LM Model (Only if we complete Chapter 20 in class)

a) In an economy operating under flexible exchange rates, explain why the IS curve

is downward sloping.

b) Explain what the IP curve is and why it is upward sloping.

c) Suppose the domestic and foreign interest rates are both initially equal to 3%.

Now suppose the domestic interest rate rises to 5%. Explain what effect this will

have on the exchange rate. Also explain what must occur for the interest parity

condition to be restored.

d) Suppose the domestic and foreign interest rates are both initially equal to 4%.

Now suppose the foreign interest rate rises to 6%. Explain what effect this will

have on the exchange rate. Also explain what must occur for the interest parity

condition to be restored.

e) Explain what effect each of the following events will have on the IS curve in a

flexible exchange rate regime: (1) an increase in foreign output; (2) a reduction in

the foreign interest rate; and (3) an increase in the domestic interest rate. Show

each of these effects in a diagram.

f) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,

graphically illustrate and explain what effect an increase in government spending

will have on the domestic economy. In your graphs, clearly label all curves and

equilibria.

g) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,

graphically illustrate and explain what effect monetary contraction will have on

the domestic economy. In your graphs, clearly label all curves and equilibria.

h) Assume the exchange rate is allowed to fluctuate freely. Using the IS-LM-IP model,

graphically illustrate and explain what effect a reduction in foreign output (Y*)

will have on the domestic economy. In your graphs, clearly label all curves and

equilibria.

i) For a country pursuing a fixed exchange rate regime, what does the interest parity

condition imply about domestic and foreign interest rates? Explain.

j) To what extent can monetary policy be used to affect output in a fixed exchange

rate regime? Explain.

k) Assume the exchange rate is fixed. Using the IS-LM model, graphically illustrate

and explain what effect a reduction in consumer confidence will have on the

domestic economy. In your graphs, clearly label all curves and equilibria.

l) Assume that policy makers are pursuing a fixed exchange rate regime. Now