EC326 INTERNATIONAL ECONOMICS II
MODEL ANSWERS FOR UE
JUNE 2018
SECTION A
Question one
#
a
b
c
d
e
f
g
h
i
j
ANS
FALSE
TRUE
FALSE
FALSE
FALSE
FALSE
TRUE
FALSE
TRUE
FALSE
Question two
#
i
ii
iii
iv
v
vi
vii
viii
ix
x
ANS
A
C
A
B
A
D
D
C
A
A
Question three
a
#
i
ANS
NOT CHANGE
ii
iii
INCREASE
DECREASE
b
i
ii
iii
NOT CHANGE
NOT CHANGE
NOT CHANGE
c
i
ii
iii
iv
INCREASE
NOT CHANGE
NOT CHANGE
NOT CHANCE
Question four
a)
b)
c)
d)
S=750
I=750,
NX=0,
Real exch. rate =1.
SECTION B
Question five
We have seen from q3c, as a result of increase in government expenditure the variables involved
will change in the following ways
 Equilibrium income will increase
 Nominal exchange rate will not change
 Trade balance will not change
The following is the economic reasoning why
 Implementation of this policy will raise aggregate demand in the economy and hence
output will increase
 However the resulting government budget deficit increases the demand for loanable
funds which increases interest rate
 Increased interest rate will lead to currency appreciation
 But the CB is committed to maintaining a fixed exchange rate: this will force the CB to
implement expansionary monetary policy to decrease interest rate. The resulting lower
interest rates will depreciate the currency back to its fixed level
 Since there is no change in exchange rate, trade balance will not change because
exchange rate is the only determinant of trade balance in the Mundell-Fleming model
 Since the period under analysis is short run, the Mundell-Fleming model assumes that
there is rigidity in prices; that is prices have no enough time to respond to changes in
demand conditions in economy
This is illustrated by the following diagram of the Mundell-Fleming model
In the above diagram.. The increase in government expenditure shifts the IS curve from
IS1 TO IS2 . This raises output from Y1 to Y2, this puts an upward pressure on exchange
rate by forcing it to appreciate. However the CB is committed to maintain the level of
exchange rate at e1. Therefore, the CB will have to implement expansionary monetary
supply that shifts the LM curve form LM1 to LM2.
Question six
a) Under flexible exchange rate a reduction in interest rate reduces the demand for domestic
assets which in turn reduces the demand for domestic currency. Lower demand for
domestic currency leads to currency depreciation. This causes output to increase in two
ways
 Lower interest rate increases incentives for investment which raises aggregate
demand
 Currency depreciation lowers the relative prices of domestic goods leading to an
increase in net exports. Increase in net exports in turn increase aggregate demand
Consumption will increase. Consumption is a function of disposable income. Due to an
increase in output or income, disposable income will increase leading to an increase in
consumption (5 Marks)
Investment will increase (5 marks with explanation): investment will increase because of
the following two reasons
 Because interest rate is a price of borrowing financial resources for investment,
Lower interest rate increases incentives for investment
 Increase in output will boost investors confidence on the economy and will induce
more investment
b) If we assume net exports depend on both exchange rate and income, the effect on net
exports is ambiguous. Net exports have negative relationship with income and positive
relationship with exchange rate. From the explanation in a above, lower interest rates
leads to currency depreciation and an increase in income. Whereas currency depreciation
lowers the relative prices of domestic goods leading to an increase in net exports,
increased output increases imports that lead to a decrease in net exports. In this case the
effect on net exports is ambiguous
If we assume net exports only depend on exchange rate, net exports will increase.
Currency depreciation lowers the relative prices of domestic goods leading to an increase
in net exports (10 marks)
Question seven
Question eight
Economic growth refers to the rate at which output per capita is increasing over time. The Solow
model offers a fundamental explanation of ways in which economic growth takes place.
According to the Solow model, a country can achieve and sustain higher rates of economic
growth by achieving technological progress. However the Solow model is silent about the
causes of technological progress: that is technological progress is endogenous in the Solow
model.
The endogenous growth theory covers this gap by attributing technological progress to
investment s in human capital. According to the two-sector model, there are two sectors, the
research sector and manufacturing sector. According to this model, increasing the number of
people employed in the research sector leads to an increase in the rate of technological progress.
Workers in the research institution are important for technological change as they engage in
research and development activities regarding new production methods to be used in the
manufacturing sector.
Therefore investment in education is crucial for achieving sustainable increase in standard of
living