Problem Set 8
You may work in groups, but you must turn in your own answers. For the conceptual questions,
copying an answer directly from any source (the article, your classmates, an online source) is considered
plagiarism and will result in a zero for that question. Everything should be in your own words and
demonstrate that you read the required articles. For analytical questions, you will not be graded on
getting the correct answer, but it needs to be clear that you gave an honest attempt for every question.
Conceptual Questions
1. Read the article “Fix or float?”. What are the costs and benefits of using a fixed vs floating
exchange rate? Why is a fixed exchange rate sometimes hard to maintain (Bonus: look up what
happened to Mexico in 1994 and Thailand in 1997)?
2. Read the article “The Trilemma of International Finance.” Explain what the “Trilemma” means
and how the US, China, and Europe have chosen di!erent ways of controlling their monetary and
foreign exchange policies.
3. Explain the di!erences between Hayek’s and Keynes’s views on business cycles and the role of
government intervention. In particular you should comment on what each viewed as the cause of
business cycles and what they thought the government should do during a recession. You may find
it helpful to read the article “Friedrich August Hayek” and watch the Keynes-Hayek rap battles
(“Fear the Boom and Bust” and “Fight of the Century”).
4. Read the article ”How Did the US Achieve a Soft Landing?” Briefly explain the four theories
proposed by Smith in the article. Which of the four do you find most convincing?
1
Analytical Questions
1. An open economy is described by the following equations
C = 1000 + 0.6(Y → T )
I = 20, 000 → 200r
G = 5000
T = 5000
MD
P
= 2Y → 800r
MS
= 60, 000
P
CA = N X = 2000 → 0.1Y → 1000ω
KA = 5500 + z(r → r→ )
r→ = 10
(a) Derive the IS curve (Y as a function of r and ω), LM curve (Y as a function of r) and the
BP curve (r as a function of Y , ω, and the capital mobility parameter z)
(b) Assuming free capital mobility (z ↑
→ ↓) and a flexible exchange rate, solve for the equilibrium
interest rate, income, exchange rate and trade balance.
(c) If government spending increases by 1800, what happens to the interest rate, exchange rate,
income, and trade balance? Draw the change on a graph.
(d) Return to the original level of G. If the money supply increases by 20,000, what happens to
the interest rate, exchange rate, income, and trade balance? Draw the change on a graph.
(e) Repeat b through d assuming a fixed exchange rate of ω = 4 (remember that when the
exchange rate is fixed the money supply will adjust to keep it fixed so you should also solve
for equilibrium M
P )
(f) Repeat b through e assuming imperfect capital mobility with z = 100 (do your best - this is
not covered on the exam, but it is a good challenge to see if you really know what you are
doing.)
2
1)A floating currency allows countries to utilize the exchange rate to
adjust to shocks in the economy. The cost to a floating currency is that
surges in capital cause the currency to swing drastically. It also steers
investors away with its ability to be volatile, which makes it difficult to
combat inflation. The benefit is that it requires investors to act constantly
in accordance with fluctuations in the economy and helps policymakers
with decision-making. With a fixed exchange rate, prices and wages
within the country are used to respond to shocks. The benefit is stability
which encourages investement because it promotes confidence within
investors. The costs are that monetary policy cannot impact the interest
rates and it requires large reserves which makes it difficult to maintain.
2) The “trillemma” is that countries want to allow foreign investment,
stabilize the economy through monetary policy, and create stability within
the foreign exchange rate. All three of these cannot co-exist, creating this
dilemma. The US allows foreign investment and monetary policy to
stabilize its economy. China utilizes monetary policy and stabilizes the
foregin exchange rate, but they do not allow foreign investment. Europe
allows foreign investment and stabilizes the foreign exchange rate, but
they cannot stabilize their domestic economy through monetary policy.
3) Hayek believes that the market is unplanned and that actions can only
be coordinated if there is less involvement from the government. He
believes that business cycles are driven by low interest rates that are
artificial which throws firms off in investing.Hayek argues for less
government intervention, and Keynes argues for more. Keynes argued
that recessions are caused by aggregate demand decreases. He believed
in more overnmetn intervention to increse spending or cut taxes.
4) The first theory is that a series of shocks to aggregate supply that were
temporary but eventually faded back into its original state. The second
theory is that aggregate supply acts independently of aggregate demand,
and price level is only determined by supply conditions. Monetary and
fiscal policy have no impact on interest. The third theory is that stimulating
the economy led to an increase in aggregate demand whilst supply chain
issues impacted aggregate supply and once the issues concluded, the
demand and supply returned back to its original state. The fourth theory is
that inflation aligns with what people believe the Fed will do in the future.
The Fed signaled low inflation which led to lower prices in 2022, and
because it occurred quickly, unemployment was not affected. I find the
fourth theory to be most convincing because it uses a theory of
expectations and follows consumer behavior.