Question

Exercise No. 1 (60 points) Suppose an economy for which we know that there is a fixed exchange rate of 1500 diner/$. Explain and graph (IS/LM and money market) what effect it would have on the interest rate if the current exchange rate is 800 diner/$.

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Dexter

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91 Answers

1. **Identify the exchange rate disparity:**

- Fixed exchange rate: 1500 \, \text{diner/}\$

- Current exchange rate: 800 \, \text{diner/}\$

2. **Analyze the impact on the economy's demand:**

- The current exchange rate (800 diner/$) is lower than the fixed rate (1500 diner/$).

- This implies that the domestic currency is undervalued compared to the fixed exchange rate.

3. **Effect on the IS curve:**

- An undervalued domestic currency makes exports cheaper and imports more expensive.

- This leads to increased demand for domestic goods, shifting the IS curve to the right.

4. **Effect on the LM curve and the money market:**

- Higher output and income from increased demand raise the demand for money.

- With the money supply fixed, the increased demand for money raises the interest rate.

5. **Conclusion:**

\text{The interest rate will rise.}

- Fixed exchange rate:

- Current exchange rate:

2. **Analyze the impact on the economy's demand:**

- The current exchange rate (800 diner/$) is lower than the fixed rate (1500 diner/$).

- This implies that the domestic currency is undervalued compared to the fixed exchange rate.

3. **Effect on the IS curve:**

- An undervalued domestic currency makes exports cheaper and imports more expensive.

- This leads to increased demand for domestic goods, shifting the IS curve to the right.

4. **Effect on the LM curve and the money market:**

- Higher output and income from increased demand raise the demand for money.

- With the money supply fixed, the increased demand for money raises the interest rate.

5. **Conclusion:**

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