Name: _________________________________________________
HW 9 (45 points) con 307 Due 12/11/2022
A small open economy is in a recession and policymakers wish to promote economic growth through higher trade. That is,
the goal is to ?NX to ?Y.
Assume that Mexico is the SOE, while the US is the LOE that has influence on the world financial market. The exchange
rate is defined as e = US$/Peso. Lastly, assume that the NCF between Mexico and the US is equal to zero.
A) Assume that Mexico has a flexible exchange rate system. [20 points]
A1. What would you propose as a domestic policy to promote income through trade? Just state it (you will explain
below). Would the policy temporarily lead rMEXICO to be greater or less than r*? Briefly explain.
A2. What happens to the NCF between Mexico and the US? Is it a NCI or NCO? Write down the NCF equation and
explain how the two parts in that equation will change.
NCF =
A3. How would the NCI or NCO affect the exchange rate in the foreign exchange market (FEM)? Explain the changes in
the demand and the supply of Pesos in the FEM. Explain why NX and Y will increase.
A4. Illustrate your policy choice on this IS*/LM* graph. Identify on your graph the increased NX and Y.
e
LM*1
e1
IS*1
Y
Y1
B) Assume that Mexico is now adopting a fixed exchange rate system (e.g. peg the peso to the US dollar). [25 points]
B1. What would you propose as a domestic policy to promote income through trade? Just state it (you will explain below).
Would the policy temporarily lead rMEXICO to be greater or less than r*? Briefly explain.
B2.What happens to the NCF between Mexico and the US? Is it a NCI or NCO? Write down the NCF equation and
explain how the two parts in that equation will change.
NCF =
B3. How would the NCI or NCO affect the market exchange rate relative to the fixed exchange rate (??? )? Explain the
changes in the demand and the supply of Pesos in the FEM.
B4. Given that e differs from ??? , explain the arbitrage that will ensue in returning the market exchange rate (e) back to the
fixed exchange rate level. Specifically, explain how the actions of the arbitrageurs and the Mexican Central Bank would
alter the money supply and bring back e to ??? .
B5. Illustrate your policy choice on an IS*/LM* graph. Show the increased NX and Y on your graph.
e
LM*1
e1 = ???
IS*1
Y
Y1

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