Macroeconomic Theory





When the interest parity condition holds and the domestic interest rate is greater than the foreign interest rate then the domestic currency is expected to decrease in value alongside the foreign currency thus a high inflation is expected in the country.

Q 1b

If the nominal interest rate is 2% in the United States and 5% in Canada one is expected to hold the United States bonds than the Canadian bonds since the high interest rate in Canada indicates expected inflation rate in the country to be high. Thus the Canadian dollars is expected to decrease in value against the United States dollar by 3% in regard to international Fisher effect.

E(e) = i$US -i $C

2% – 5% = -3%

Qc i

The market conditions may be summarized as follows:

I $= 5%, I UK pounds= 2%, S =$1.68per US pound, F= $1.55 per US pounds.

If $100 million is invested in United States, maturity value in one year will be

$100 M ( 1+0.05) = $ 105 million or

$100M may be converted to the UK pounds and be invested at the UK interest rate, with pounds maturity value sold forwarded.

($100 M *1.68)(1+.02)(1/1.55) = $109.8 M

This clearly indicates that it’s better to invest $100M in the UK.

Q C ii

Because the rate of inflation is high in the U.S, we can apply the buying power parity to estimate the exchange rate in pounds today.

E (e) = E pounds$ – E$

= 2% – 5% = – 3%

E(St) = So(1 + E(e))

= ( $1.68 per pound) (1+0.03)

= $1.68504

= $1.69 per pound.

Q2 a

Effect of reduction in taxes on output, exports, imports and net exports

A reduction in lump sum taxes may improve the economy through increased output, exports and net exports. The IS curve shifts to the right from IS to IS2. The LM curve also shifts to the right from point LM to LM1. This is illustrated in the graph below.







704857105650047244089217500 When there is a reduction in the foreign trade by one unit, but the domestic government increases spending by one unit. The will be a reduction in the domestic output, exports, net exports and imports. This is due to the changes in foreign exchange rates that affect also the domestic market. The effect tend to shift the IS curve to the left Ss1 toS2 and equilibrium point moves from E0 toE1.

7931158001000 LM













Full employment curve

As the aggregate demand (AD) curve moves in, expansionary monetary policy may be implemented for AD to shifts back to starting point, output is now restored.


The rise in government expenditure results in the curve of IS to shift to the right and an economy moves from point A to B. at this point there is a deficit in balance of payments leading to depreciation in the exchange rate. Net Exports rises as the relative rate of domestic products on global market has reduced.






When the domestic interest rates remain constant at 4% while the foreign interest rate increase to 6% the expected exchange rate for the domestic currency will appreciate against the foreign currency because inflation rate in the foreign market is high. The interest parity may be restored when domestic market sells its foreign reserves in order to move to 4% exchange rate or equilibrium.

Q31557655635000008064570548500bAn increase Government spending will shifts the curve of IS to the right IS- IS1. The shift leads to an increase in rate of interest. A rise in government expenditure forces the fiscal policy to provide the market with local exchange to uphold the rate of exchange constant.


26727152997200010045701841500133667524955500 LM1





Q3 c

An expansionary monetary authority will move the LM curve to LM1 thus making the equilibrium to shift from point E to E1. And because the trade rates are flexible, the deficit in balance of payments will devalue the domestic money. This will results to rise in the net exports moving the IS curv





In order to maintain the pegged exchange rate when foreign interest falls. The fiscal policy makers must purchase the foreign assets through home currency. And these increase the supply of domestic money that shifts economy to its final equilibrium. There will be enhanced output through buying of domestic assets and low exports.


The effect of increased consumer confidence in domestic economy in a fixed exchange rate. There will be increased government spending, increase in aggregate demand resulting to shift of DD1 to DD2 while the original appreciation falls from E1 to E2. The central bank is forced to acquire foreign assets by home currency. This moves the economy to equilibrium E3 at a higher output.


A country which is in a fixed exchange rate such as China might be expected to depreciate its currency due to the following factors: the government has to invest a lot of resources in order to get foreign reserves to grow up so as to defend the fixed exchange rate. And also there is monetary ineffective as the only option in the independent fiscal policy is the exchange controls that avert traders from selling or buying domestic currency. But these exchange controls decrease trade and direct investment in foreign and encourages essence of corruption.


The actions that policy makers may choose in response to expected currency devaluations. They can opt to reduce exchange rate and sell foreign reserves. The government can also purchase domestic assets. Taxes should be reduced to raise aggregate demand to increase appreciation in the currency.


When the economy is operating below the natural level of output. The labor supply falls with unemployment going back to its normal rate. This only results in reduced output and the only option are to increase inflation in order reduces unemployment. Devaluation of currency will rise the inflation further other creating of employment. An increase in aggregate demand only causes to rise.

Q 4d

An economy that is operating above the natural level of output in a fixed exchange rate regime can adjust to this situation through a decrease in the domestic currency to enhance a rise in output as net export increase.