Homework # 7

International Finance

Miguel D. Ramirez

1. Suppose that you are given the following absorption and trade balance relationships for a certain fixed exchange rate economy:

A = A + aY  T = T - mY

A = 400 + 0.8Y; T = 60 - 0.1Y

with all symbols as defined in class, and all variables are measured in real terms (billions of real dollars).

a. What is the equilibrium level of income in the economy? What is the value of the Keynesian open economy multiplier? Is it smaller than that of a closed economy?  Why?  What is the balance of trade? Is the balance in surplus or deficit?

b. Suppose there is an exogenous decrease in the foreign demand for domestic exports reflected in an autonomous trade balance decrease of 30 billion. what is the effect on

i) the equilibrium level of income in the economy?

ii) the trade balance?

c. Consider now the effect of an exogenous increase in government spending of 30 billion. What would be the effect on

i) the equilibrium level of income?

ii) the value of exports, imports, and the trade balance?

2. You are advising the government of El Salvador that currently has a trade balance of zero but is facing a high rate of unemployment. You are told that the economy is under a system of fixed exchange rates, and you are given the following information:

a. The marginal propensity to import is 0.2.

b. The marginal propensity to save is 0.1

c. The price elasticity of demand for imports is 1.5.

d. The price elasticity of demand for exports is 2.0.

e. Domestic exports (which equal the value of imports) are 100 million pesos.

i) Suppose that the government decides to devalue the peso by 10 %. What would be the impact on the trade balance and on the equilibrium level of income? Give a numerical answer and explain.