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Answered Same Day Dec 29, 2021

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David answered on Dec 29 2021

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Econ 304 Summer 2012
Problem Set #6 Due by 11:59 PM MST July 20
1. (5 points each part)
Suppose the government in a small developing economy places restrictions on agricultural
exports in order to increase the domestic food supply and lower food prices. Use the Mundell-
Fleming model to analyze the short run effects of this policy on the exchange rate and real GDP
if the country has a:
a. Fixed exchange rate
Answer:
Due to restriction on agricultural export, net export will fall in the economy, leading to leftward
shift in the IS curve. This would cause in fall in the domestic interest rate i.e. domestic interest
ate would become less than foreign interest rate and fall in the real GDP (because aggregate
demand has gone down). As a result, there would huge outflow of capital, leading to depreciation
of domestic cu
ency or increase in exchange rate (defined as units of domestic cu
ency per
foreign cu
ency unit). In order to keep exchange rate fixed, the central bank would intervene
the foreign exchange market by selling the foreign cu
ency in return for domestic cu
ency, and
as a result money supply would fall in the economy, causing LM curve to shift leftward. This
would
ing the exchange rate to its initial level but will further reduce the real GDP. Thus under
fixed exchange rate regime, the export restriction would have no effect on exchange rate but real
GDP will fall.
. Floating exchange rate
Answer:
Here also due to restriction on agricultural export, net export will fall in the economy, leading to
leftward shift in the IS curve. As explained above, this would cause in fall in the domestic
interest rate i.e. domestic interest rate would become less than foreign interest rate and fall in the
eal GDP (because aggregate demand has gone down). As a result, there would huge outflow of
capital, leading to depreciation of domestic cu
ency or increase in exchange rate (defined as
units of domestic cu
ency per foreign cu
ency unit). Thus we note that under floating exchange
ate regime, the export restriction would cause depreciation of domestic cu
ency and fall in the
Real GDP.
2. (5 points each part)
Business executives and policymakers are often concerned about the competitiveness of
American industry (the ability of U.S. industries to sell their goods profitably in world markets).
a
How would a change in the nominal exchange rate affect competitiveness in the short run when
prices are sticky?
Answer:...

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