Long-run equilibrium

A small open economy can be described by the following equations:
Full-employment level of output: YFE = 12500
DD equation: Y = 8700 + G – 150P + 200EDC/FC
AA equation: Y = 2000 + 5(
𝑀𝑆
𝑃
) + 50Ee – 40EDC/FC
In the initial long-run equilibrium, the government collects 9% of the nation's long-run level of
national income as taxes and it runs a budget surplus of 225. Also, the level of (nominal) money
supply is 28700 and the expected DC/FC exchange rate (Ee
) is 25.
a) Find the long-run equilibrium exchange rate and price level. (6 points)
The economy is initially in its long-run equilibrium as described in part (a). Suppose there is a
change in the preference of holding money such that the new AA equation is:
AA equation: Y = 1940 + 5(
𝑀𝑆
𝑃
) + 50Ee – 40EDC/FC
In addition, a permanent shock will cause the expected exchange rate to change by 0.6 DC per FC.
b) Suppose the economy adopts a flexible exchange rate, answer the following questions:
• If the change is transitory, find the equilibrium levels of output and exchange rate in the
short run. (5 points)
• If both change is permanent, find the equilibrium levels of output and exchange rate in the
short run. (7 points)
c) Suppose the economy adopts a fixed exchange rate, and the official rate is set at the one
calculated in part (a). In addition, the fixed exchange rate is maintained by a change in real
money supply. Answer the following questions:
• If the change is transitory, find the equilibrium levels of output and real money supply in
the short run. (4 points)
• If both change is permanent, find the equilibrium levels of output and real money supply
in the short run. (4 points)
• Do you get the same answers for both temporary and permanent changes? Yes/No, explain
your answer (i.e., why the answers are not the same or not the same). (4 points)