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Q2. Mundell-Fleming model. (10 marks) Consider an open economy IS-LM model. China's currency is the “Chinese...

Q2. Mundell-Fleming model.

Consider an open economy IS-LM model. China's currency is the “Chinese Yuan Renminbi

(CNY)" and the USA's currency is the “US dollar (USD)". China has a fixed exchange rate regime

with respect to USD. The central bank of China maintains a peg of 1 CNY=0.14 USD. The interest

rate in the USA is 2.5%.

a. What do the above facts imply about the interest rate in China? Explain. (2 points)

b. Suppose that the USA experiences an increase in output ??∗. With the help of a diagram explain

the short-run effects of the increase in ??∗ on the economy of China. What happens to output and

net exports? Carefully label your diagram

c. Suppose the USA Federal Reserve Bank conducts an expansionary monetary policy and lowers

its interest rate to 2%. How will the central bank of China react if it wants to maintain the exchange

rate peg? What will be the effect of this on the interest rate in China? (2 points)

d. Following part (c), with the help of a diagram explain the short-run effects of the foreign

expansionary monetary policy on the economy of China. What happens to output and net exports?

(2 points)

e. Suppose instead that China decides to abandon the fixed exchange rate regime and to adopt a

flexible exchange rate regime. With the help of a diagram explain how your answers in part (b)

would change? What would happen to output, net exports, and nominal exchange rate?

Expert Solution

Rahul Sunny answered 2 years ago

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