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5 Cards in this Set
- Front
- Back
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In an economy operating under flexible exchange rates, explain why the IS curve is downward sloping. |
An increase in the interest rate reduces output both directly (by reducing investment) and indirectly (through the exchange rate by reducing net exports); so the IS curve is downward sloping. |
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Explain what the IP curve is and why it is upward sloping. |
The IP curve is a relation b/w interest rate and exchange rate, implied by interest parity. Higher domestic interest rate causes higher exchange rate, so the curve slopes up. |
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Suppose the domestic and foreign interest rates are both initially equal to 3%. Now suppose the domestic interest rate rises to 5%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored. |
The exchange rate will increase. For interest parity to be restored, the foreign currency must appreciate by 3%. |
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Suppose the domestic and foreign interest rates are both initially equal to 4%. Now suppose the foreign interest rate rises to 6%. Explain what effect this will have on the exchange rate. Also explain what must occur for the interest parity condition to be restored. |
Exchange rate will decrease. To restore interest parity, domestic currency must appreciate by 2%. |
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For a country pursuing a fixed exchange rate regime, what does the interest parity condition imply about domestic and foreign interest rates? Explain. |
They must be equal and money supply must adjust to maintain this interest rate. |
