Quiz 22: How Does the Open Macroeconomy Work


I disagree to the statement that a recession in the US economy would raise the growth of real GDP in Europe. A recession could lead to a point in US where the local GDP could become lower due to higher prices chasing lesser goods which can lead to shift in consumer demand and lower international trade of goods and services. The aggregate demand of any country includes international trade net import/export level as a measure. This could lead to a lower import in the US which could invariably affect a set of smaller countries driving down the demand for their produce making the GDP lower for these nations. Based on the past experiences such as the great depression of 1930s and the housing crisis of 2007 we all know that a slowdown of larger economies such as the US, Euro area, Japan and China could be contagious and decrease the growth in the entire world as economies are very much interconnected. Thus, a recession in the US economy would rather lower the growth of real GDP in Europe.

a. The marginal propensity to save iS0.15 and the marginal propensity to import iS0.4 which gives us the marginal propensity to consumption aS0.45 img Since the government has reduced the spending by 2 billion the domestic product will be reduced by 0.9 billion as the income change which is not redistributed domestically is img i.e. 0.45 and the import savings will be the leakages to the economy, hence 1.1 billion is the domestic product. b. The marginal propensity to import is current at 40 cents and since there is reduction of spending of government by 2 billion the change in country's imports will be a reductioN0.8 Billion c. If this is a large country it means that the reduction in government spending can lead to a reduction of money spent abroad hence a reduction in demand of foreign product by 0.8 Billion img as the imports are reduced and income will reduced by 0.9 billion affecting the domestic spending and demand for imported goods d. This change in foreign product and income will tend to counteract the change in first country's domestic product and income as the foreign product demand or demand for imports will be reduced and hence the income from abroad due to exports will increase. The domestic consumption will shrink making the available resources to be remobilized will reduce.

The FE curve referred to as the foreign exchange curve has a lot to do with the current account balance a country keeps with its foreign counter parts. This is determined based on the level of domestic currency outstanding with the foreign currency balances and hence determines if an economy is in deficit or surplus. A deficit may lead to the right shift of the upward sloping FE curve to have an equilibrium point with the domestic goods and vice versa. If the balance of payments herein referred as (B) is zero which means there is no deficit nor surplus then the country is said to have achieved external balance. The FE curve or the foreign exchange market is characterized by the all combinations of the domestic product levels(Y) and interest rates(I) for which the foreign exchange market is in equilibrium. In other words FE curve indicates various equilibrium points which is a combination of domestic product and interest rates, although there could be certain deviations in the short run, long run always makes it get back to the point within the FE curve which slopes upward hence the external balance is a point achieved based on the prevalent conditions of both the economies.