Problem Set #5 ANSWERS. Due Tuesday, April 29, 2008

Transcription

1 Name: SID: Discussion Section: Poblem Set #5 ANSWERS Due Tuesday, Apil 29, 2008 Poblem Sets MUST be wod-pocessed except fo gaphs and equations. When dawing diagams, the following ules apply: 1. Completely, clealy and accuately label all axes, lines, cuves, and equilibium points. 2. The oiginal diagam and any equilibium points MUST be dawn in black o pencil. 3. The fist change in any vaiable, cuve, o line and any new equilibium points MUST be dawn in ed. 4. The second change in any vaiable, cuve, o line and any new equilibium points MUST be dawn in blue. 5. The thid change in any vaiable, cuve, o line and any new equilibium points MUST be dawn in geen. Poblem Set #5 (Sping 2008) 1/9

2 QUESTIONS A. Multiple Choice Questions. Cicle the lette coesponding to the best answe. (1 points each.) 1. Which of the following would be pat of the nation s capital and financial account? a. A night club show seen by an Ameican in Mexico City. b. A dividend fom a Bitish equity owned by an Ameican. c. A payment to the Philippine govenment fo the use of militay bases in thei county. d. One hunded shaed of Bitish Petoleum stock puchased by an Ameican. 2. A small open economy inceases its investment demand. This causes the wold eal inteest ate to and the county s cuent account balance to. a. Rise; fall. b. Remain unchanged; ise. c. Rise; ise. d. Remain unchanged; fall. 3. A lage open economy educes its investment demand. This causes the wold eal inteest ate to and the county s cuent account balance to. a. Rise; fall. b. Rise; ise. c. Fall; ise. d. Fall; fall. 4. Assume that an incease in Costa Rica s govenment budget deficit educed desied national saving by 10 million colon (the Costa Rican cuency). Assuming Costa Rica is a small open economy, you would expect the govenment s action to: a. Incease the cuent account balance by exactly 10 million colon. b. Incease the cuent account balance by less than 10 million colon. c. Reduce the cuent account balance by exactly 10 million colon. d. Reduce the cuent account balance by moe than 10 million colon. 5. Fom 1980 to 2000, the ye/dolla exchange ate fell fom 240 yen/dolla to 102 yen/dolla, while the dolla pound exchange ate fell fom 2.22 dollas/pound to 1.62 dollas/pound. As a esult, a. The dolla appeciated elative to the yen but depeciated elative to the pound. b. The dolla depeciated elative to the yen but appeciated elative to the pound. c. The dolla appeciated elative to both the yen and the pound. d. The dolla depeciated elative to both the yen and the pound. Poblem Set #5 (Sping 2008) 2/9

3 6. If the eal exchange ate aised 2%, domestic inflation is 3%, and foeign inflation is 1%, what is the pecent change in the nominal exchange ate? a. 6%. b. 4%. c. 2%. d. 0%. 7. Thee has been a eal depeciation of the dolla ove the past month. In the long-un, you would expect the quantity of: a. Ameican impots to fall and the quantity of Ameican expots to fall. b. Ameican impots to ise and the quantity of Ameican expots to ise. c. Ameican impots to fall and the quantity of Ameican expots to ise. d. Ameican impots to ise and the quantity of Ameica expots to fall. 8. An incease in domestic output would cause a in net expots and a in the exchange ate. a. Rise; ise. b. Rise; fall. c. Fall; ise. d. Fall; fall. 9. A decease in the foeign eal inteest ate would cause the domestic county s net expots to and cause the domestic county s IS cuve to. a. Rise; shift to the ight. b. Rise; shift to the left. c. Fall; shift to the ight. d. Fall; shift to the left. 10. If a county has an ovevaluation poblem, the best solution is to: a. Incease the official ate. b. Buy less of its cuency in the foeign exchange maket. c. Sell moe of its cuency in the foeign exchange maket. d. Decease the money supply. Poblem Set #5 (Sping 2008) 3/9

4 B. Answe BOTH of the following questions. (10 points each.) 1. S d I d Open Economy Model. Suppose that the wold economy is composed of only two lage, open-economy counties the United States and China and that the U.S. is unning a substantial cuent account deficit. Because of xenophobic feas, the Chinese govenment then imposes stict capital contols that pevent Chinese esidents and institutions fom eithe boowing o lending aboad. a. Based only on this infomation, use a 2-county S d I d Open Economy diagam to accuately and clealy show: 1. The initial equilibium situation in both counties (in black), 2. The shot-un effects on national saving, desied investment, the cuent account balance, and eal inteest ates in both the U.S. and China fom this policy change (in ed), United States S China S CA > 0 w w CA < 0 I I S d, I d S d, I d Poblem Set #5 (Sping 2008) 4/9

5 b. Povide a bief economic explanation fo the changes you showed in you diagams above. Be sue to compae the cuent account balances and eal inteest ates between the initial and final shot-tem equilibium situations fo both counties. Initially, befoe capital contols ae imposed, the wold inteest ate is at w. The United States has a cuent account deficit, measued as the negative diffeence between its national saving and desied investment at the wold inteest ate. This indicates that the U.S. is boowing fom China. China has a cuent account suplus, measued as the positive diffeence between its national saving and desied investment at the wold inteest ate. This indicates that China is lending to the U.S. China s cuent account suplus exactly equals the United States cuent account deficit. Afte China imposes capital contols, each county must intenally finance all of its desied investment, i.e., inteest ates must move to equilibate national saving and desied investment. Because the United States was boowing intenationally (befoe capital contols wee imposed), domestic inteest ates will ise in ode to incease national saving and educe desied investment. Once national saving and desied investment equilibate, the cuent account balance will be zeo. Because China was lending intenationally (befoe the capital contols wee imposed), domestic inteest ates will fall in ode to educe national saving and incease desied investment. Once national saving and desied investment equilibate, the cuent account balance will be zeo. Compaing the initial and final equilibium situations: Fo the United States, domestic inteest ates ae highe and the initial cuent account deficit has disappeaed. Fo China, domestic inteest ates ae lowe and the initial cuent account suplus has disappeaed. Poblem Set #5 (Sping 2008) 5/9

6 2. Open Economy IS-LM Model with the Foeign Exchange Maket. Fance and Gemany ae majo tading patnes with flexible exchange ates. Because Gemany is expeiencing acceleating inflation, the Bundesbank (Gemany s cental bank), engages in a contactionay monetay policy. a. Based only on this infomation, use a 2-county, open economy IS-LM model with an Foeign Exchange Maket diagam to accuately and clealy show: 1. The initial geneal equilibium situation in both counties (in black), 2. The shot-un effects on economic output, the eal inteest ate, and the nominal and eal exchange ates in both Fance and Gemany fom the Bundesbank s monetay contaction (in ed). LM 1 Gemany LM 0 Fance LM IS 0 IS 1 IS 0 Y 1 Y 0 Y Y 1 Y 0 Y S 2 P DM S 1 S 0 P 2 P 0 D 2 D 0 Poblem Set #5 (Sping 2008) 6/9 Q DM

7 b. Povide a bief economic explanation fo the changes you showed in you diagam above. Be sue to compae the level of economic output, the eal inteest ate, and the nominal and eal exchange ates between the initial and shot-un equilibium situation in both counties. Both Gemany and Fance ae initially in equilibium with economic output at Y 0 and with the eal inteest ate at 0. Gemany s contactionay monetay policy shifts its LM cuve to the left fom LM0 to LM1. This causes the eal inteest ate to incease fom 0 to 1. The incease in the eal inteest ate educes inteest-sensitive spending and economic output falls fom Y 0 to Y 1. The decease in Gemany s economic output fom Y 0 to Y 1 also educes Gemany s impots and, theefoe, inceases its net expots. A decease in impots causes a eduction in the supply of Geman Deutschmaks in the foeign exchange maket, shifting the supply cuve to the left fom S 0 to S 1. The incease in Gemany s eal inteest ate fom 0 to 1 inceases the demand fo Geman Deutschmaks in the foeign exchange maket, shifting the demand cuve to the ight fom D 0 to D 2. The highe eal inteest ate also deceases the supply of Geman Deutschmaks in the foeign exchange maket, shifting the supply cuve to the left fom S 1 to S 2. As a esult of these changes in the foeign exchange maket the Geman Deutschmak will appeciate, both in nominal and eal tems in the shot un, fom P 0 to P 1. The appeciation of the Deutschmak will make Fench impots less expensive and incease Geman impots. Howeve, the decline in impots fom the decline in Geman economic output has a lage effect than the incease in impots fom the appeciation of the Geman cuency. Consequently, Geman impots decline and net expots incease. If Geman net expots incease, Fench net expots must decease. This causes the Fench IS cuve to shift to the left fom IS 0 to IS 1. As a esult, Fench economic output declines fom Y 0 to Y 1 and Fench inteest ates decline fom 0 to 1. The net effect of all of these changes in the shot un ae: Both Gemany and Fance have lowe levels of economic output. Gemany has a highe eal inteest ate while Fance has a lowe eal inteest ate. The Geman Deutschmak has appeciated in both nominal and eal tems while the Fench Fanc has depeciated in both nominal and eal tems. [In the long-un, of couse, the pice level in Gemany will adjust to being the economy back to its full-employment output level so thee will be not pemanent effect on eal vaiables, including the eal exchange ate.] Poblem Set #5 (Sping 2008) 7/9

8 Now suppose that instead of having had flexible exchange ates, Fance had fixed its exchange ate with Gemany at its fundamental value, a level that Fance is committed to maintaining. c. Based only on this infomation, use a 2-county, open economy IS-LM model with an Foeign Exchange Maket diagam to accuately and clealy show: 3. The initial geneal equilibium situation in both counties (in black), 4. The shot-un effects on economic output, the eal inteest ate, and the nominal and eal exchange ates in both Fance and Gemany fom the Bundesbank s monetay contaction (in ed), Gemany LM 1 LM 0 Fance LM 2 LM = 0 1 IS 0 IS 1 IS 0 Y 1 Y 0 Y Y 2 Y 1 Y 0 Y S 2 P DM S 1 S 0 = S 3 P 2 P 0 = P 3 D 2 D 3 D 0 = D 4 Poblem Set #5 (Sping 2008) 8/9 Q DM

9 d. Povide a bief economic explanation fo the changes you showed in you diagam above. Be sue to discuss how Fance must espond to Gemany s monetay contaction to maintain the fixed exchange ate. Also discuss what happens to Fance s economic output, eal inteest ate, eal exchange ates, and net expots in the shot un assuming that Fance is successful in maintaining the fixed exchange ate at its initial fundamental value. The fist pat of this section is exactly the same as in pat a and b. Howeve, if Fance wants to offset Gemany s contactionay monetay policy to keep it fom affecting the exchange ate, Fance must also use a contactionay monetay policy. When Gemany uses a contactionay policy it causes Fance s IS cuve to shift to the left because its net expots must decline. To pevent its nominal exchange ate fom declining, Fance must itself use a contactionay monetay policy to shift its LM cuve to the left fom LM 0 to LM 2. The contactionay monetay policy causes Fance s economic output to decline fom Y 1 to Y 2 and its eal inteest ates to incease fom 1 to 2. The decease in Fance s economic output fom Y 1 to Y 2 also educes Fance s impots (o Gemany s expots). This decease in Fance s impots causes a decline in the demand fo Geman Deutschmaks in the foeign exchange maket, shifting the demand cuve to the left fom D 2 to D 3. The incease in Fance s eal inteest ate fom 1 to 2 inceases the supply of Geman Deutschmaks in the foeign exchange maket, shifting the supply cuve to the ight fom S 2 to S 3. The highe Fench eal inteest ate also educes the demand fo Geman Deutschmaks in the foeign exchange maket, shifting the demand cuve to the left fom D 3 to D 4. As a esult of these vaious changes in the foeign exchange maket, the nominal exchange ate will be unchanged. Because the pice levels in each county do not change in the shot un, the eal exchange ate is also unchanged. The effect on net expots is ambiguous. Both Fance and Gemany have declines in economic output, so the effect on net expots depends on the sensitivity in each county of net expots to changes in economic output. Poblem Set #5 (Sping 2008) 9/9