1. Two countries, North and South, have identical closed economies. In the short run both can be
described by the IS-LM model. The fiscal authorities of North and South both increase taxes by
identical amount. The Central Bank of North follows a policy of holding a constant money supply.
The Central Bank of South follows a policy of holding a constant interest rate. Compare the impact
of the tax increase on income and interest rates in the two countries. Explain briefly. Be sure to
label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift;
and v. the terminal equilibrium values.
2. The economic indicators in the country of Brinkland, a closed economy, signal that the country is
in equilibrium, both in the good and services market and in the market for money. You are hired as
an advisor to the Central Bank of Brinkland.
a. The Congress of Brinkland embarks on a policy to balance the budget and, hence, increases
lump-sum taxes. Use the IS-LM model to illustrate the effects of this policy graphically
and explain briefly to the central bankers. Be sure to label: i. the axes; ii. the curves; iii. the
initial equilibrium values; iv. the direction the curves shift; and v. the terminal equilibrium
values.
b. Given the policy above, what should the central bank of Brinkland do if they want to avoid
a recession? Illustrate the effects of this policy graphically and explain briefly. Be sure to
label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves
shift; and v. the terminal equilibrium values.
3. Assume that your advice to the central bankers of Brinkland is so effective that its short-run
equilibrium real GDP is now at a level above its natural rate. Take this as your starting point and
use the IS–LM model to illustrate graphically how the levels of income and interest rates change as
the economy of Brinkland returns to the natural rate of output in the long run. Explain briefly. Be
sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves
shift; and v. the terminal equilibrium values.
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4. Brinkland’s authorities now decide to open their economy to trade and let the exchange rate float
freely, although they know their economy is too small to affect international markets. The
Congress of Brinkland maintains its policy to balance the budget and, hence, increases lump sum
taxes. Illustrate graphically the short-run impact of this policy on the exchange rate (no. of foreign
currency per unit of Brinkland’s currency) and output of Brinkland. Explain briefly. Be sure to
label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift;
and v. the new short-run equilibrium.
5. Assume that the LM curve for a small open economy with a floating exchange rate is given by Y =
200r – 200 + 2(M/P), while the IS curve is Y = 400 + 3G – 2T + 3NX – 200r. The function for NX
is NX = 200 – 100e, where e is the exchange rate. The price level (P) is fixed at 1.0. The
international interest rate is r
*
= 2.5 percent.
a. Using the LM curve, find the equilibrium level of Y in the small open economy, if M = 100.
b. Given this value of Y, if G = 100 and T = 100, what must be the equilibrium value of NX?
c. If this value of NX is to be achieved, what must be the equilibrium exchange rate, e?
6. Two small open economies, Fixus and Flexus are otherwise identical except that Fixus maintains a
fixed exchange rate, while Flexus maintains a flexible exchange-rate regime. The governments of both
countries decrease spending by the same amount. Compare what happens in the two countries to:
a. the exchange rate
b. equilibrium output
c. net exports.
