Lesson 7

Question 1

what is one the assumptions of the IS-IM model regarding price level?

Answer 1

One of the assumptions of the IS-LM model is that the price level is constant

Question 2

what happens to the domestic price level in an open model in the short run?

Answer 2

In an open model in the short run, this means that the domestic price level (P) as well as the foreign price level remain unchanged (P*)

Question 3

when the domestic price level is given, is there any inflation?

Answer 3

no

Question 4

what are net exports?

Answer 4

we also group exports (X) and imports (IM) together and refer to them as net exports (NX).

Question 5

what happens to investment spending when interest rates increases?

Answer 5

An increase in the interest rate leads to a decrease
in investment spending, the demand for goods
and the level of output and income

Question 6

what is the result of a decrease in output and income and what is the reason?

Answer 6

The decrease in output and income is a multiple of
the decrease in investment spending. This is due
to the multiplier effect.

Question 7

what does a depreciation of the exchange rate results?

Answer 7

A depreciation of the exchange rate results in an
increase in exports and a decrease in imports due
to expenditure switching, thus the trade balance
improves

Question 8

what does the increase in exports and expenditure results to?

Answer 8

The increase in exports and expenditure switching increases the demand for goods and the
level of output and income

Question 9

what is the formula for the expenditure of the goods market?

Answer 9

Y = C(Y–T) + I(Y,i) + G + NX(Y,Y*,E)

Question 10

what are the 2 important variables that are part of the equilibrium condition in the goods market?

Answer 10

nominal exchange (E) and the
nominal interest rate (i).

Question 11

what are the 2 different bonds investors will choose and how do they choose which bond to go for?

Answer 11

In an open economy, financial investors have a choice between domestic bonds and
foreign bonds and in this choice domestic or foreign financial investors will go for the
highest expected rate of return

Question 12

what is the type of return financial and foreign bonds will have in the equilibrium?

Answer 12

This implies that in equilibrium both domestic bonds
and foreign bonds must have the same expected rate of return.

Question 13

what is an interest parity equation?

Answer 13

a relationship between the domestic interest rate and the nominal exchange rate is derived.

Question 14

what are the components of the interest parity?

Answer 14

The nominal exchange rate (E)

The expected exchange rate (at the end of the period Ee)

The domestic interest rate (i)

The interest rate (i*)

Question 15

what is an interest parity formula?

Answer 15

nominal rate (E)= 1 + domestic interest rate/1 + interest rate times expected interest rate

Question 16

why is the IS curve downward sloping?

Answer 16

In a closed economy, this is because of the negative relationship between the interest rate and the level of
output and income.

Question 17

what does a decrease in interest rates affect investment spending, the demand for the level of output and income?

Answer 17

A decline in the interest rate increases investment spending, the demand for goods and the level of output and income.

Question 18

does the decline in the interest rates causes an appreciation or depreciation of the nominal exchange rate?

Answer 18

A decline in the interest rate causes a depreciation of the nominal exchange rate

Question 19

what causes domestic bonds to be less attractive and capital outflow to occur?

Answer 19

The depreciation of the nominal exchange rate is the result of the decrease in the domestic
interest rate relative to the interest rate in the rest of the world. This causes domestic
bonds to be less attractive and a capital outflow occurs

Question 20

how does the capital outflow affects the demand for the domestic currency and the exchange rate?

Answer 20

This capital outflow reduces the demand for the domestic currency (it increases the
demand for foreign currency) and the exchange rate depreciates,

Question 21

what does the depreciation of the exchanges causes the price exports and the demand for goods and the level of output?

Answer 21

The depreciation of
the exchange rate reduces the price of exports and exports increase which, in turn, increases the demand for goods and the level of output and income

Question 22

in terms of the IS-IM model, how is the domestic equilibrium interest rate determined?

Answer 22

In terms of the IS-LM model, the domestic equilibrium interest rate ( ¯i) is determined
by the central bank

Question 23

on what curve is the goods market represented?

Answer 23

The goods market is represented by the IS curve and the financial market by the LM curve.

Question 24

how does an increase in the interest rate affect the LM curve?

Answer 24

an increase in the interest rate by the central bank, shifts the LM curve upwards

Question 25

what is the monetary contraction when the central bank increases?

Answer 25

The central bank increases the interest rate: monetary contraction -> i ( increased)

Question 26

in the goods market, how does the increase of the interest rate affect investment spending?

Answer 26

In the goods market, an increase in the interest rate causes a decline in investment spending, which decreases the demand for goods and the level of output and, in turn, a decline in income.

Question 27

as consumption spending decreases, how does that affect the level of output?

Answer 27

Consumption spending decreases as a result of the
decrease in the level of output and income and disposable income.

Question 28

how does the increase of interest rates affect capital inflows and how does the increase of the nominal exchange affect domestic currency?

Answer 28

The increase in the interest rate causes an increase in capital inflows; the nominal exchange rate increases and the domestic currency appreciates (prices are assumed to be fixed in the IS-LM model; therefore a nominal appreciation of the domestic currency will lead to a real appreciation of the domestic currency).

Question 29

how does the appreciation of the domestic currency affect the price of exports and net exports?

Answer 29

An appreciation of the domestic currency increases the price of exports and the net exports position worsens.

Question 30

how does the decrease of the level of output and income affects the second round in imports?

Answer 30

The decrease in the level of output and income leads to a second round decrease in
imports and an increase in the trade balance

Question 31

how does an increase in government spending shifts the IS curve?

Answer 31

an increase in government spending, shifts the IS curve to the right

Question 32

does the fiscal policy affect the LM curve or interest parity and why?

Answer 32

Fiscal policy will not affect the LM curve or the interest parity curve and since the interest rate is set by the central bank, the interest rate will be unchanged.

Question 33

how does an increase in government spending affect the demand for goods and services and the level of output?

Answer 33

An increase in government spending causes a rise in the demand for goods and the
level of output and income increases.This has a multiplier effect on the level of output
and income, and in the process, the level of consumption spending increases as well. A positive relationship exists between the level of output and investment spending. In
terms of figure 7.4(A) below, this is indicated by a rightward shift in the IS curve.

Question 34

since the interest rate is set by the central bank, will the interest rate and exchange rate remains unchanged or changed?

Answer 34

Since the interest rate is set by the central bank, the interest rate will be unchanged
(i = ¯i ) and therefore the exchange rate is also unchanged.

Question 35

what does the increase in the level of output and income affect the demand for money and the quality of money?

Answer 35

The increase in the level of output and income will increase the demand for money
and the quantity of money

Question 36

how\ does the increase in the level of output and income results affect imports and the deterioration of the trade balance?

Answer 36

The increase in the level of output and income results in an increase in imports and a
deterioration of the trade balance