Question

Consider an economy that abides by a standard Mundell-Fleming model with perfectly sticky prices, imperfect capital mobility, and flexible exchange rates. Suppose the foreign economy lowers its interest rate (assume this shock first manifests in the IS/LM/BoP space).

1. Consider the initial reaction of the shock. Which is true?

A. IS curve shifts left due to the change in the foreign interest rate.

B. IS curve doesn’t change since the foreign interest rate isn’t part of the IS curve.

C. IS curve shifts right due to the change in the foreign interest rate

D. The IS curve becomes steeper, but the shift direction is ambiguous

2. Consider the initial reaction of the shock. Which is true?

A. BoP doesn’t change due to perfect capital mobility.

B. BoP shifts up because domestic rates are higher than foreign rates

C. BoP shifts down, reflecting the lower foreign interest rates

D. The BoP becomes steeper, reflecting greater international interest rate differentials

3. The initial reaction in the IS/LM/BoP space generates

A. BoP surplus

B. BoP deficit

C. BoP balance

D. The result is ambiguous

4. The foreign exchange market will react in the following way

A. The Supply of FX rises due to higher domestic output

B. The Demand for FX falls due to the stronger domestic output

C. The Demand for FX rises due to the relatively higher domestic interest rate

D. The Demand for FX falls due to the relatively higher domestic interest rate Page 3

5. What is the impact on the USD?

A. Dollar strengthens

B. Dollar weakens

C. Dollar remains unchanged

D. The impact is ambiguous

6. In response to the change in the US$, the IS/LM/BoP system will equilibrate in what manner?

A. Only the LM curve will shift right

B. Only the IS curve will shift left

C. The IS curve shifts shifts left and the BoP shift Up slightly

D. Only the BoP shifts up

Answer 1

Suppose the foreign economy lowers its interest rate.

1. IS curve include domestic consumption, investment, government expenditure and net exports of goods and services. As interest rate decreases in foreign economy it does not cause any shift in IS curve as it is not a determinant of IS curve. So the solution is B. IS curve doesn’t change since the foreign interest rate isn’t part of the IS curve.

2. Due to lower foreign interest rate, there will be an increase in Capital inflow in domestic economy which cause BOP curve to shift right or downward. So the solution is C. BoP shifts down, reflecting the lower foreign interest rates.

3. As there is an increase in capital inflow in the economy due to lower foreign interest rate. There will be a Surplus in Capital account of BOP which cause surplus in BOP as well.

4. Now people want to invest less in foreign economy and more in domestic economy so there will be higher supply into the economy of foreign exchange and less demand of foreign exchange within the economy. So the answer is D. The Demand for FX falls due to the relatively higher domestic interest rate.