URGENT
Imagine that you run the Central Bank of India. Your goal is to stabilize income, and you
adjust the money supply accordingly. Under your policy, what happens to the money supply,
the interest rate, the exchange rate, and the trade balance in response to each of the following
shocks?
a. The Government raises taxes to reduce the budget deficit (10 marks)
b. The Government restricts the import of Japanese cars.(10 marks)
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a) A rise in the rate of interest (holding the discount rate constant and assuming for
simplicity an initial situation of r = ρ) implies positive growth of consumption. In turn, this
means a reduction in current consumption (the present value of wealth falls).
b) If the individual’s discount rate goes up, consumption growth is negative. The
individual wants to consume a larger share of their life-time income now so current
consumption goes up.
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