(a) Assume that R denotes the domestic interest rate and R ...

[madam-professor]

(a) Assume that R denotes the domestic interest rate and R denotes the foreign interest rate.
 
  Under a fixed exchange rate what is the relation between R and R (b) Assume E denotes the domestic currency price of the dollar for a country which is not the United States. If one wants to analyze only the short run effects of a policy, what does one assume about the Home and Foreign price levels, P and P , respectively. (c) Assume that there is no ongoing balance of payment crisis. What is this assumption really assume? (d) Assume a fixed exchange rate system. What does this tell you about E? (e) Under the above assumptions what are the conditions for internal balance? (f) How is your answer to Part D above would change if P is unstable due to foreign inflation. (g) Given the definitions above, how one defines the real exchange rate? (h) Write the condition for internal balance. (i) Define the variable not defined before in Part G above. (j) Using the equation for internal balance derived above, given our assumptions analyze the effects of a fiscal expansion. (k) What would happen if the government of that country, which is not the United States under Bretton Woods, decides to devaluate its currency? (l) What would happen if the government of that country, which is not the United States under Bretton Woods, decides to use monetary policy rather than fiscal policy? (m) Given all of the above, what is the relation between the exchange rate, E, and fiscal ease, i.e., an increase in G or a reduction in T? (n) Assume that the economy is at internal balance. What will happen if G goes up for a given level of E? (o) Assume that the economy is at internal balance. What will happen if G goes down for a given level of E?

Question 2

If an economy is in a liquidity trap, then the nominal interest rate is ________ and the only effective policy that can be used to stimulate the economy is ________.
 
  A) zero or negative; expansionary fiscal policy
  B) zero or negative; expansionary monetary policy
  C) high and rising; contractionary monetary policy
  D) high and rising; expansionary monetary policy
  E) high and rising; expansionary fiscal policy

[vickyvicksss]

Answer to Question 1

(a) R = R
(b) Constant prices.
(c) That Ee, the expected exchange rate, is equal to the exchange rate today, E. In other words, E = Ee.
(d) E is constant, i.e., E = E0.
(e) Since P and E are fixed, the expected price is fixed; thus, no inflation is expected. Then, internal balance will require only full employment, aggregate demand equaling the full-employment level, Yf.
(f) In this case, full employment alone will not guarantee price stability under a fixed exchange rate.
(g) The real exchange rate is equal to EP /P.
(h) Yf = C(Yf - T) + I + G + CA(EP /P, Yf - T)
(i) C = consumption, I = Investment, (Yf - T) = disposable income, T = taxes.
(j) An increase in G or a reduction in T will increase aggregate demand and will cause output to rise in the short run.
(k) A rise in E makes domestic goods and services cheaper relative to those sold abroad and thus increases demand for output.
(l) A monetary policy is not a policy tool under fixed exchange rates. Under fixed exchange rates, domestic asset transactions by the central bank can be used to alter the level of foreign reserves but not to affect the state of employment and output.
(m) Negative relation.
(n) Over-employment.
(o) Under employment.

Answer to Question 2

A