Question:
4. True, False or Uncertain. For each of the following statements determine if the statement is TRUE, FALSE, or UNCERTAIN. You must justify your answer either graphically or in words. No credit will be given without an explanation.
A. "An increase in the nominal exchange rate (e) will cause the IS* curve to shift to the right."
B. "If the value of the currency is reduced via a devaluation in a fixed exchange rate regime, then income will rise, but net exports will remain unchanged."
C. "A raising of credit card transaction fees (which causes an increase in the demand for money) will lead to a recession according to the IS-LM model."
D. "If Congress cuts government spending in order to reduce the budget deficit, the Federal Reserve can keep the economy from falling into a recession by conducting an open market sale
<u>Answer to A is True</u>
This explanation will require the following model which has the following components:
This model uses the following variables:
<em>Y</em> is real GDP
<em>G</em> is real government spending (an exogenous variable)
<em>T</em> is real taxes levied
<em>NX</em> is real net exports
<em>M</em> is the exogenous nominal money supply
<em>P</em> is the exogenous price level
<em>i</em> is the nominal interest rate
<em>L</em> is liquidity preference (real money demand)
<em>C</em> is real consumption
<em>I</em> is real physical investment, including intended inventory investment
Explanation:
Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending.
Higher disposable income is created when there is an increase in salaries.
Lower interest rate happens when intentionally the Central Bank decides to resuscitate the economy or prevent the economy from sliding into a recession. Either way, the IS curve which comprises Consumption and Investment spending shifts to the right.
The components of the IS* Curve are given below:
Where <em>E(π) equals the inflation rate expected.</em>
<u></u>
<u>Answer to B is </u><u><em>False</em></u>
The Mundell – Fleming model was used to demonstrate that an economy can not sustain a fixed exchange rate, free movement of capital and an independent monetary policy at the same time. Only two of the three can be maintained by an economy at the same time. This concept is also called the "<em>impossible trinity."</em>
<em />
<em>Devaluation</em> is a method used by monetary authorities to improve the balance of trade in the country by improving exports at moments when the trade deficit can become an economic issue.
<u>Answer to C is </u><em><u>False</u></em>
Increase in card transaction fees will does not decrease the demand for money or it decreases the demand for <u>credit</u>. It has no way of creating a recession since demand for money is not affected directly.
<u>Answer to D is </u><em><u>True</u></em>
When expenses surpass revenue and suggest a country's financial safety, a budget deficit occurs. This form of spending is usually characterised by heavy importation especially by the government. So on one hand, the government can <em>truly </em> can cut back on expenses to reduce the deficit.
On another hand, the government can conduction an open market sale to prevent the economy from falling into recession. An Open Market refers to the buying and selling of government bonds by the Federal reserve.
If a bank buys a government bond from the Federal Reserve, the bank acquires capital that it can lend out. The supply of money is expected to increase. Buying on an free market brings money into the economy.
This increase can be balanced by slamming high tax rates on importation or outrightly prohibiting them. That way, money is circulated internally and there is a push pressure on exports which gradually, along with a shift in the Investment and Consumption curves bring about a turn around in the economy.
Cheers!