Problems

1. (Static Mundell-Fleming with imperfect capital mobility). Let the trade balance be given by α(s + p − p) − ψy. A real depreciation raises exports and raises the trade balance whereas an increase in income leads to higher imports which lowers the trade balance. Let the capital account be given by θ(i−i ), where 0 < θ < ∞ indexes the degree of capital mobility. We replace (8.3) with the external balance

condition

α(s + p − p) − ψy + θ(i − i ) = 0,

that the balance of payments is 0. (We are ignoring the service account.) When capital is completely immobile, θ = 0 and the balance of payments reduces to the trade balance. Under perfect capital mobility,

θ= ∞ implies i = i which is (8.3).

(a)Call the external balance condition the FF curve. Draw the FF curve in r, y space along with the LM and IS curves.

(b)Repeat the comparative statics experiments covered in this chapter using the modiÞed external balance condition. Are any of the results sensitive to the degree of capital mobility? In particular, how do the results depend on the slope of the FF curve in relation to the LM curve?

2.How would the Mundell-Fleming model with perfect capital mobility explain the international co-movements of macroeconomic variables in Chapter 5?

3.Consider the Dornbusch model.

(a)What is the instantaneous e ect on the exchange rate of a shock to aggregate demand? Why does an aggregate demand shock not produce overshooting?

(b)Suppose output can change in the short run by replacing the IS curve (8.7) with y = δ(s − p) + γy − σi + g, replace the price adjustment rule (8.8) with pú = π(y−y¯), where long-run output is given by y¯ = δ(¯s − p¯) + γy¯ − σi + g. Under what circumstances is the overshooting result (in response to a change in money) robust?