Reference no: EM131521015

1. Consider a group of open economies; assume perfect capital mobility.

a. Assume there is a Leader country. All other countries (referred to as Follower countries) fix their exchange rates vis-à-vis the Leader country. Discuss the effectiveness of monetary policy in the Follower countries.

b. If all countries fix their exchange rate vis-à-vis the Leader country, isn't the Leader country's exchange rate also fixed? What does this imply for the effectiveness of the Leader country's monetary policy?

c. If the Leader country raises its interest rate to fight inflation, what must the Follower countries do to maintain their fixed exchange rates? What is the effect on their economy? What would happen in Follower countries if they did not change their interest rates?

2. Consider the Mundell-Fleming (open economy IS-LM) model. Assume that there is a flexible exchange rate regime. In all cases consider the effects in two cases: when the central bank keeps the interest rate unchanged and when it changes it to avoid possible inflationary/deflationary pressures.

a. Show the effect of a decrease in foreign output, Y*, on domestic output, and net exports. Y.

b. Show the effect of an increase in the foreign interest rate, i*, on domestic output and net exports when the domestic central bank keeps the interest rate fixed. Explain in words.

c. "A monetary policy contraction abroad may well lead to a recession at home." Discuss.

d. "A fiscal policy contraction abroad will lead to a recession at home" Discuss. Consider the cases when the foreign central bank keeps the interest rate unchanged or decreases it.