Question

Question 1: This question is based on chapter 08.
The Danish krone is currently pegged to the euro. Using the IS–LM–FX model for Home (Denmark) and Foreign (Eurozone), illustrate how each of the following scenarios affect Denmark:
A. The Eurozone reduces its money supply.
B. Denmark cuts government spending to reduce its budget deficit.
C. The Eurozone countries increase their taxes.

Answer 1

Change in monetary policy will change the can be reflected through M.

Change in fiscal policy can be reflected through G (government spending )or T (Tax).

i) Referring to the figure, Eurozone reduced the money supply so the M/P decrease which implies LM decrease, out decreased Y1 to Y2 and Interest increased from i1 to i2, so the exchange rate decreased from E1 to E2.

ii) Denmark's government decreased government spending. that G decreased that shift IS left, D decreased to Y4, I shift down to i1, output shift to Y4 and the exchange rate comes back to E1.

iii) Eurozone increased its tax, which will affect the IS curve further. so there is a shift in IS curve left, output further decreased to Y5, interest rate decreased ti i3 and that implies an increase in the exchange rate to E3. overall in this case domestic country, Denmark is in a loss position due to decrease government spending along with increased foreign tax.