HOMEWORK 10 (ON CHAPTER 18 FIXED EXCHANGE RATES AND FOREIGN EXCHANGE INTERVENTION) ECO41 FALL 2015 UDAYAN ROY

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1 HOMEWORK 10 (ON CHAPTER 18 FIXED EXCHANGE RATES AND FOREIGN EXCHANGE INTERVENTION) ECO41 FALL 2015 UDAYAN ROY Each correct answer is worth 1 point. The maximum score is 20 points. This homework is due at 9:30 am on Monday, December 14. I will hold a review session at that time. Attendance is not required. If you do not wish to attend the review session, please me your answers or hand it in at the Economics Department s offices in Hoxie Hall. Of the ten homework assignments, I will consider only your top six scores in calculating your course grade. 1. Suppose the domestic country s central bank has decided to fix the exchange rate so that the exchange value of the foreign currency will stay fixed at E = E target. Suppose the exchange value of domestic currency has nevertheless fallen below the target value (that is, E > E target ; remember that a high value of E means a low value of the domestic currency). What would the domestic country s central bank have to do to return the exchange rate to the target level? a. Sell financial assets from its reserves. This will increase the domestic money supply as well as the domestic central bank s reserves of financial assets. b. Sell financial assets from its reserves. This will reduce the domestic money supply as well as the domestic central bank s reserves of financial assets. c. Print additional amounts of the domestic currency and buy financial assets with it. This will increase the domestic money supply as well as the domestic central bank s reserves of financial assets. d. Print additional amounts of the domestic currency and buy financial assets with it. This will increase the domestic money supply and reduce the domestic central bank s reserves of financial assets. 2. Suppose the domestic country s central bank has decided to fix the exchange rate so that the exchange value of the foreign currency will stay fixed at E = E target. Suppose the exchange value of domestic currency has nevertheless fallen below the target value (that is, E > E target ; remember that a high value of E means a low value of the domestic currency). Which of the following is true? a. The central bank will be able to restore E = E target by printing additional amounts of the domestic currency and buying financial assets with it. b. The central bank will be able to restore E = E target by selling financial assets. If it runs out of financial assets to sell, it will have to abandon its efforts to fix the exchange rate. In that case, E > E target will continue to prevail. c. The central bank will be able to restore E = E target by selling financial assets. Its ability to fix the exchange rate will not depend upon the value of the financial assets it currently owns. d. The central bank will be able to restore E = E target, but one cannot say whether the central bank would have to buy financial assets or sell financial assets to achieve its goal. e. The central bank will be unable to achieve its goal of E = E target. Only when E < E target can the central bank re-establish E = E target. 3. Suppose the domestic country s central bank has decided to fix the exchange rate. Moreover, suppose that most people believe that the central bank will be able to keep the exchange rate fixed at the target rate for the foreseeable future. Then, the interest parity condition (of Ch. 14) implies that

2 a. the foreign interest rate must equal the domestic interest rate b. the foreign interest rate must equal the domestic interest rate plus the domestic inflation rate c. the foreign interest rate must be less than the domestic interest rate d. the foreign interest rate would be unrelated to the domestic interest rate 4. When a country s central bank fixes the exchange rate, it gives up its ability to a. adjust taxes b. increase government spending c. influence the economy through fiscal policy d. depreciate the domestic currency e. influence the economy by controlling the supply of money 5. When a country s currency is devalued: a. Output decreases. b. Output increases. c. The money supply decreases. d. The money supply increases. e. both (b) and (d) 6. Which one of the following statements is the most accurate? a. Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline. b. Any central bank purchase of assets results in an increase in the domestic money supply, while any central bank sale of assets causes the money supply to decline. c. Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline. d. Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to increase. e. None of the above statement is true. 7. Under a fixed exchange rate system, the following condition should hold for domestic money market equilibrium: a. M s = P L(R *, Y). b. M s = P L(R, Y). c. M d = P L(R *, Y). d. M s = L(R *, Y). e. P = L(R *, Y). 8. Which one of the following statements is the most accurate? a. Fiscal policy has the same effect on output under fixed and flexible exchange rate regimes. b. Fiscal policy affects output more under fixed than under flexible exchange rate regimes. c. Fiscal policy affects output less under fixed than under flexible exchange rate regimes. 2

3 d. Fiscal policy cannot affect output under fixed exchange rate but does affect output under flexible exchange rate regimes. e. None of the above statements are true. 9. Which one of the following statements is the most accurate? a. A devaluation occurs when the central bank lowers E target (its target for the domestic currency price of foreign currency) and a revaluation occurs when the central bank raises E target. b. A devaluation occurs when the central bank raises E target and a revaluation occurs when the central bank lowers E target. c. A devaluation occurs when the domestic currency price of foreign currency, E, increases and a revaluation occurs when E decreases. d. A devaluation occurs when the central bank of the foreign country raises the domestic currency price of foreign currency, E, and a revaluation occurs when the central bank of the foreign country lowers E. e. None of the above statements is true. 10. Which of the following is true? a. When a devaluation is anticipated before it occurs, E = E e = E target is true both before and after the devaluation. Consequently, the interest parity equation (of Chapter 14) implies that the domestic interest rate remains equal to the foreign interest rate throughout (R = R*). b. When a devaluation comes as a surprise, E increases but E e remains unchanged. Consequently, the interest parity equation (of Chapter 14) implies that the domestic interest rate initially falls below the foreign interest rate when devaluation occurs (R < R*). c. When a devaluation comes as a surprise, E increases but E e remains unchanged. Consequently, the interest parity equation (of Chapter 14) implies that the domestic interest rate initially rises above the foreign interest rate when devaluation occurs (R > R*). d. Both (a) and (b) are correct 11. Under fixed exchange rate, which one of the following statements is the most accurate? a. Devaluation causes a decrease in output, a decrease in official reserves, and a contraction of the money supply. b. Devaluation causes a rise in output, a rise in official reserves, and an expansion of the money supply. c. Devaluation causes a rise in output and a rise in official reserves. d. Devaluation causes a rise in output and an expansion of the money supply. e. Devaluation causes a rise in official reserves, and an expansion of the money supply. 12. Recall that absolute purchasing power parity is often assumed in long-run international macroeconomic analysis. If, in addition, the domestic economy fixes the exchange rate, which one of the following statements is the most accurate? a. The domestic nominal interest rate would be determined by the foreign nominal interest rate, because R = R*. b. In the long run, the domestic inflation rate would be determined by the foreign inflation rate: that is, π = π*. 3

4 c. It would no longer be possible to expand the money supply to fight a recession. d. The uncertainty of exchange rate fluctuations would no longer be a big headache. e. All of the above are true. Miscellaneous 13. Tariffs, which are taxes on imported goods and services, can raise output (Y) and the current account balance (CA) a. in both the long run and the short run, under fixed exchange rates but not under flexible exchange rates b. in neither the long run nor the short run c. in the short run but not in the long run, and under fixed exchange rates but not under flexible exchange rates d. in the long run but not in the short run e. in the short run but not in the long run, and under both flexible and fixed exchange rates 14. A country can increase its the current account balance (CA) a. by implementing contractionary fiscal policy (G and/ or T ). This is effective in the short run and in the long run, under fixed exchange rates and under flexible exchange rates. b. by implementing expansionary fiscal policy (G and/ or T ). This is effective in the short run and in the long run, under fixed exchange rates and under flexible exchange rates. c. by implementing contractionary fiscal policy (G and/ or T ). This is effective only in the short run and only under flexible exchange rates. d. by implementing expansionary fiscal policy (G and/ or T ). This is effective only in the short run and only under flexible exchange rates. e. by implementing contractionary fiscal policy (G and/ or T ). This is effective only in the short run and only under fixed exchange rates. 15. A country can increase its the current account balance (CA) a. by implementing contractionary monetary policy. This is effective in the short run and in the long run, under fixed exchange rates and under flexible exchange rates. b. by implementing contractionary monetary policy. This is effective only in the short run and only under flexible exchange rates. c. by implementing expansionary monetary policy. This is effective only in the short run and only under flexible exchange rates. d. by implementing expansionary monetary policy. This is effective only in the short run, under fixed exchange rates and under flexible exchange rates. e. by implementing contractionary monetary policy. This is effective only in the short run and only under fixed exchange rates. 16. Which of the following is true? a. Fiscal policy is expansionary when taxes decrease and/or government spending increases. Monetary policy is expansionary when money supply increases (M s under flexible exchange rates) or the domestic currency is devalued (E target under fixed exchange rates). 4

5 b. Fiscal policy is contractionary when taxes decrease and/or government spending increases. Monetary policy is expansionary when money supply increases (M s under flexible exchange rates) or the domestic currency is devalued (E target under fixed exchange rates). c. Fiscal policy is expansionary when taxes decrease and/or government spending increases. Monetary policy is expansionary when money supply increases (M s under fixed exchange rates) or the domestic currency is devalued (E target under flexible exchange rates) d. Fiscal policy is expansionary when taxes decrease and/or government spending increases. Monetary policy is contractionary when money supply increases (M s under flexible exchange rates) or the domestic currency is devalued (E target under fixed exchange rates) 17. Expansionary monetary policy affects output (Y) and current account balance (CA) in the short run as follows: a. Y and CA b. Y and CA c. Y and CA d. Y and CA 18. Irrespective of the exchange rate system, expansionary fiscal policy (G and/ or T ) will cause output to increase (Y ) a. In the long run, but not in the short run b. In both the long run and the short run c. In neither the long run nor the short run d. In the short run, but not in the long run 19. Irrespective of the exchange rate system, expansionary monetary policy will cause output to increase (Y ) a. In the long run, but not in the short run b. In both the long run and the short run c. In neither the long run nor the short run d. In the short run, but not in the long run e. None of the above is true. Whether expansionary monetary policy will increase or decrease output depends on whether the exchange rate is fixed or flexible. 20. Consider the adjacent figure. If people widely begin to believe that a devaluation of the domestic currency is imminent, then E e will increase. As a result: a. The AA curve will shift to the right. Under a fixed exchange rate system the central bank will push the AA curve back to its original position by selling financial assets from its reserves and thereby reducing the money supply. So, an economy initially at Point 3 will remain at Point 3. b. The AA curve will shift to the left. Under a fixed exchange rate system the central bank push the AA curve back to its 5

6 original position by buying financial assets and thereby increasing the money supply. So, an economy initially at Point 1 will remain at Point 1. c. The AA curve will shift to the right. Under a fixed exchange rate system the central bank will want to push the AA curve back to its original position by selling financial assets from its reserves and thereby reducing the money supply. But if at some point the central bank runs out of financial assets to sell, it will be unable to keep the exchange rate fixed. In that case, if the economy was initially at Point 3, it will move to Point 2. The complete exhaustion of the central bank s reserve of assets followed by the abandonment of the fixed exchange rate system is called capital flight. d. Both (a) and (c) are correct. e. None of the above are correct. 21. In the diagram attached to the previous question, the short-run effects of contractionary fiscal policy can be represented as the movement of the economy from: a. Point 1 to Point 2 under flexible exchange rates, and Point 1 to Point 3 under fixed exchange rates. This shows that fiscal policy has a bigger effect on output under fixed exchange rates. b. Point 1 to Point 2 under fixed exchange rates, and Point 1 to Point 3 under flexible exchange rates. This shows that fiscal policy has a smaller effect on output under fixed exchange rates. c. Point 1 to Point 4 under flexible exchange rates, and Point 1 to Point 3 under fixed exchange rates. This shows that fiscal policy has a bigger effect under fixed exchange rates. d. Point 1 to Point 2 under flexible exchange rates, and no change in the outcome under fixed exchange rates. This shows that fiscal policy has a smaller effect under fixed exchange rates. 22. In the diagram attached to the two previous questions, the short-run effects of an increase in tariffs on imported goods can be represented as the movement of the economy from: a. Point 3 to Point 4 under fixed exchange rates, and Point 3 to Point 1 under flexible exchange rates. This shows that tariffs have a smaller effect on output under fixed exchange rates. b. Point 3 to Point 4 under flexible exchange rates, and Point 3 to Point 1 under fixed exchange rates. This shows that tariffs have a bigger effect on output under fixed exchange rates. c. Point 1 to Point 4 under flexible exchange rates, and Point 1 to Point 3 under fixed exchange rates. This shows that tariffs have a bigger effect under fixed exchange rates. d. Point 3 to Point 2 under flexible exchange rates, and no change in the outcome under fixed exchange rates. This shows that tariffs have a smaller effect under fixed exchange rates. 6

7 ANSWER SHEET HOMEWORK 10 (Ch. 18) ECO41 FALL 2015 UDAYAN ROY NAME: DATE: