ECON 3023 International Finance

Semester 2, 2024-2025

Assignment 2

1. Consider the following DD-AA model. Consumption is given by C = (1 — s)Y. The current account balance is given by CA = aE — mY The good market equilibrium condition is Y = C + I + G + CA . The interest parity condition R = R* +(Ee — E)/E holds. The equilibrium condition of the money market is Ms/P = 2Y — 2000R. Suppose initially the I = G = 100, s = 0.3, m = 0.2, a = 200, R = 0.05. The initial exchange rate is E = 1.

a. Assume that the central bank can hold the exchange rate E constant. What is the effect of an increase in government spending G by 50 on output Y?

b. How will the fiscal expansion affect the CA?

c. Find the change in real money supply Ms/P that can keep the exchange rate from changing.

d. What will happen if the central bank does not change the money supply? Will the fiscal expansion become more or less potent?

2. Using the DD-AA model, analyze the output and balance of payments effects of an import tariff under fixed exchange rates. How would the tariff affect other country? Discuss what would happen if all countries in the world simultaneously try to improve employment and the balance of payments by imposing tariffs.

3. (20 marks) Suppose we are using the CPI (consumer price index) to compute the Japanese Yen real exchange rate per Euro. The real exchange rate is determined by the relative demand and relative supply conditions between Japanese goods and European goods. The residents of Japan consume relative more of Japan export good than residents of Eurozone residents. In other words, Japanese export goods have a higher weight in the Japan CPI (consumer price index) than they do in Eurozone. Use the relative demand-relative supply diagram to analyse the changes below.

a. In the diagram with the real exchange rate based on CPI, is the relative demand curve (Japanese goods/European goods) upward sloping? Why?

b. What would be the effect on the Japanese Yen real exchange rate of a rise in the world demand for Japanese products?

c. How would the change in part b affect the nominal Yen/Euro exchange rate?

d. There is a one-off increase in the money supply of the Eurozone while the money supplies of Japan remains the same. How would the change affect the Yen/Euro real and nominal exchange rates?

e. Suppose an earthquake destroyed many production facilities in Japan. Thus the output of Japan becomes lower. What would be the effects on the Yen/Euro real and nominal exchange rates?