Consider a small open economy with a flexible exchange rate. Initially, the economy is in a...

 

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Consider a small open economy with a flexible exchange rate. Initially, the economy is in a medium-run equilibrium with Y = Yn, r = r, and the inflation rate equal to the central bank's target. a. Suppose that there is a permanent decline in government purchases. Use the medium-run diagram (with IS drawn under the assumption that r = r*) to show the effect of the decline in government purchases on the equilibrium real exchange rate. Is there a permanent effect on NX? Explain. b. Now consider the IS-LM diagram in the short-run, with the real interest rate on the vertical axis, and assume that the central bank chooses the real interest rate. Show what happens to the IS curve in the short run as a result of the fall in government purchases? What happens to output in the short run, before the central bank changes the real interest rate (or under the assumption that it takes time for the real interest rate to affect output)? c. Now suppose the economy is characterized by a Phillips curve with unanchored expectations. Given the effect on output you identified in part (b), what will happen to inflation in the short run? In order for the central bank to restore its inflation target, what level of output must it target-less than, equal to, or greater than Yn? Explain. You may use a diagram or write the Phillips curve equation to help you to answer the question, or you may answer only in words. d. To achieve the effect on output you identified in part (c), how must the central bank change the real interest rate in the short run? What will be the value of the real interest rate in the medium run? Consider a small open economy with a flexible exchange rate. Initially, the economy is in a medium-run equilibrium with Y = Yn, r = r, and the inflation rate equal to the central bank's target. a. Suppose that there is a permanent decline in government purchases. Use the medium-run diagram (with IS drawn under the assumption that r = r*) to show the effect of the decline in government purchases on the equilibrium real exchange rate. Is there a permanent effect on NX? Explain. b. Now consider the IS-LM diagram in the short-run, with the real interest rate on the vertical axis, and assume that the central bank chooses the real interest rate. Show what happens to the IS curve in the short run as a result of the fall in government purchases? What happens to output in the short run, before the central bank changes the real interest rate (or under the assumption that it takes time for the real interest rate to affect output)? c. Now suppose the economy is characterized by a Phillips curve with unanchored expectations. Given the effect on output you identified in part (b), what will happen to inflation in the short run? In order for the central bank to restore its inflation target, what level of output must it target-less than, equal to, or greater than Yn? Explain. You may use a diagram or write the Phillips curve equation to help you to answer the question, or you may answer only in words. d. To achieve the effect on output you identified in part (c), how must the central bank change the real interest rate in the short run? What will be the value of the real interest rate in the medium run?