ECON 105 Homework 2 KEY Open Economy Macroeconomics Due November 29

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1 Instructions: ECON 105 Homework 2 KEY Open Economy Mcroeconomics Due Novemer 29 The purpose of this ssignment it to integrte the explntions found in chpter 16 ok Kennedy with the D-S model nd the Money demnd (MD) Money supply (MS) model developed in lecture. You re to use flowchrts nd grphic nlysis to ssess mcroeconomic scenrio under three cse s: ) Closed Economy, ) Flexile Exchnge Rtes c) Fixed Exchnge Rtes In ech cse, the strting point is for the economy to e in equilirium. Equilirium is defined s (i) ggregte Demnd = ggregte Supply (short-run), (ii) Money demnd = Money Supply, nd (iii) if it is n open economy, of P = 0. the equivlent sttement to P = 0 is for Cndin interest rte = world interest rte. The djustment mechnism for the lnce of Pyments is s follows: If cdn r < world r (where r is the interest rte; don t worry out infltion) Then ) if Flexile ER: => CO rise, CI fll => ER flls => X rise, M fll => D rises => Y nd MD rise => cdn r rise (MD nd D shift right until cdn r = world r) ) if Fixed ER: => nk of Cnd reduces MS until cdn r = world r => reduced MS nd higher r cuses D to fll => Y to fll (D shifts left) (Further exmples of this type of flow digrm process is found in Kennedy chpter 16 ) If cdn r > world r, then you just reverse the directions in the flow chrt Regrdless of the exchnge rte regime, the finl equilirium requires tht the Cndin interest rte equl the world interest rte. Either the MD curve or the MS curve will move until this equilirium condition is met. 1

2 Using the flow digrms found in Kennedy nd the grphic nlysis from lecture, you re to explin the djustments to the Cndin economy for ech scenrio descried elow. Here is the grphs of the goods nd money mrkets in equilirium. Note tht the cdn r = world r; therefore the exchnge rte is lso in equilirium (P = 0). This is your strting point: SRS 0 r 0 = The Cndin (domestic) Money Mrket The Cndin (domestic) goods Mrket Figure 1: Initil Equilirium Using the ove grph, illustrte the mcroeconomic shock. n exmple of negtive shock is shown elow: SRS 0 P 1 D 1 Y 1 The Cndin (domestic) Money Mrket The Cndin (domestic) goods Mrket Figure 2: Exmple of negtive demnd shock Then, for ech cse (closed economy, flexile ER, fixed ER) grphiclly illustrte the djustment (if ny) tht follows the economic shock. With ech grph, supply the corresponding flowchrt (s per Kennedy chpter ). In ech scenrio, mke sure you identify wht hppens to GDP reltive its initil position. 2

3 Mcroeconomic Scenrio s Scenrio One: MS 1 SRS 0 initil (if FIXED) c (if FLEX) P 1 (if FIXED) initil (if FLEX) Y 1 C Y 2 D 1 D 2 (if FLEX) (if FIXED) The Cndin (domestic) Money Mrket The Cndin (domestic) goods Mrket Md Cow disese in Europe cretes new mrket for Cndin eef. How does the Cndin goods nd money mrket djust under oth fixed nd flexile exchnge rte. nswer: Grph show initil effect (short run) to (Goods) nd to (money) If Flex: higher cdn r => incresed cpitl inflows => increse in vlue $C net exports fll, income flls, Money demnd flls D shifts ck ( to ), MD shifts ck ( to ) If Fixed: MS increses to lower cdn r nd stop $C from rising in vlue ( to c) Increse in MS => further stimultes D ( to C) Scenrio Two: Expnsionry Fiscl Policy (increse G nd/or decrese T) Government hs decided tht the current GDP ( ) is less thn full employment. The government decides to use expnsionry Fiscl policy to stimulte the economy in hopes of incresing GDP. Illustrte nd explin the process nd the resulting equilirium when it is ) closed economy ) Fixed exchnge rte c) flexile exchnge rte. nswer the sme s Md Cow (ove) except in the closed economy cse, there is only the initil effect. 3

4 MS 1 SRS 0 I NX c P 1 C D 1 D 2 Y 1 Y 2 The Cndin (domestic) Money Mrket The Cndin (domestic) goods Mrket Scenrio Three: The economy is in equilirium s illustrted in figure One (ove). However the government hs decided tht the current GDP ( ) is less thn full employment. The government decides to use expnsionry Monetry policy to stimulte the economy in hopes of incresing GDP. Illustrte nd explin the process nd the resulting equilirium when it is ) closed economy ) Fixed exchnge rte c) flexile exchnge rte. Closed Economy: simply to in Money Mkt nd to in Goods Mkt Flex: to in Money Mkt nd to in Goods Mkt (initil effect) then Lower cdn r => cpitl outflows => fll in $C => increse D ( to C) => rise in Y leds to rise in MD ( to c) Fixed: Nothing! nk of Cnd cnnot use discretionry monetry policy 4

5 Scenrio Four: Due to the uncertinty in the Middle Est, interest rtes in Europe nd the US suddenly rise, cusing the world interest rte to rise ove the Cndin interest rte. Wht hppens if: ) Government tkes no ction nd Cnd is under flexile exchnge rte. ) nk of Cnd tkes ction under fixed exchnge rte. MS 1 SRS 0 c (Fixed) (FLEX) C D 2 D 1 The Cndin (domestic) Money Mrket The Cndin (domestic) goods Mrket If flex: cpitl outflows rise => cdn $ flls in vlue D rises ( to ) => Y rises nd MD rises ( to ) If fixed: of C reduces MS ( to c), lower MR rises cdn r nd lowers D ( to C) NOTE tht the effect on GDP (Y) is in opposite directions depending on ER rule Supplementl Questions for ssignment #2 NSWERS elow is n rticle out the U.S. dollr flling in vlue nd some of the resons why. Within the context of the models nd theory presented in the course, nswer the following questions: 1. Wht re the Twin Deficits? Why do they rise? e sure to explin the linkge. UDGET DEFICT LEDS TO TRDE DEFICIT. FOREIGNERS PREFER TO UY HIGH INTEREST US ONDS RTHER THN US GOODS. 2. From the quick fcts: 5

6 . If the U.S. Government hd lnced udget in 2005, Wht would e the pproximte current ccount position of the U.S.? SIMPLE NSWER IS THT THERE WOULD PPROX $463 ILLION TRDE DEFICIT ( ). Wht does tht suggest out the U.S. Economy. THE US ECONOMY IS NOT COMPETITIVE INTERNTIONLLY ND NEEDS TO ORROW TO FINNCE IMPORTS 3. Wht is ment y the use mentioned in the second prgrph? e specific THE US FED HS EEN PRINTING TOO MUCH US CURRENCY 4. From prgrph three:. How is the U.S. Freeloding? mke sure you nswer this in the context of the lnce of Pyments for the U.S. EXPORTING MORE THN IMPORTING ORROWING TO PY FOR IT. Wht would e your estimte of the position Chinese lnce of Pyments ccounts: their current nd cpitl ccounts (surplus/deficit)? THE REVERSE OF US CURRENT ND CPTIL CCOUNTS (OVERLY SIMPLE SSUMPTION, UT GOOD ENOUGH) c. Would you expect the Chinese currency to e overvlued or undervlued? Wht does this suggest out their overll lnce of pyments position (surplus or deficit)? CHIN IS PROLY RUNNING P SURPLUS ND HS UNDERVLUED CURRENCY. d. Is the informtion in this prgrph out Chin consistent with country running lnce of pyments surplus? YES. GOVT OF CHIN LIKELY TRYING TO MXIMIZE THE TRDE OPPORTUNITY WITH US ND CRETE ECONOMIC GROWTH IN CHIN. 5. Wht re two things the U.S. government could do to stop the fll of the U.S. dollr? USE FOREIGN RESERVES ND GOLD TO PROP UP US DOLLR (SHORT RUN ONLY). RISE INTEREST RTES 6