ECON 2123 Review Question 3

Transcription

1 ECON 2123 Review Question 3 TA: Mr. Ding Dong May 6, Open Economy Macroeconomics Question 1: Japan produces and exports only cameras, and Saudi Arabia, produces and exports only barrels of oil. Initially, Japan exports 40 cameras to Saudi Arabia and imports 64 barrels of oil. The real exchange rate is 4 barrels of oil per camera. Neither country has any other trading partners. a. Initially, what is the real value of Japans net exports, measured in terms of its domestic good? b. The real exchange rate falls to 3 barrels of oil per camera. Although the decline in the real exchange rate makes oil more expensive in terms of cameras, in the short run there is relatively little change in the quantities of exports and imports, as Japans exports rise to 42 cameras and its imports fall to 60 barrels of oil. What has happened to the real value of Japans net exports? c. In the longer run, quantities of exports and imports adjust more to the drop in the real exchange rate from 4 to 3, and Japans exports rise to 45 cameras and its imports of oil fall to 54 barrels. What are Japans real net exports now? d. Relate your answers to parts (b) and (c) to the J- curve concept. Draw the J-curve and explain. Solution: a. Real value of Japans net exports = 40-64/4 = 24 cameras. b. Real value of Japans net exports = 42-60/3 = 22 cameras. c. Real value of Japans net exports = 45-54/3 = 27 cameras. d. Initially, in part (b), X, IM are less responsive, ɛ decreases, so NX = X IM/ɛ decreases. Eventually, in part (c), X increases, IM and ɛ decrease, so NX = X IM/ɛ increases. It matches with the J-curve effect, where depreciation deteriorates trade balance initially, but improves eventually. 1

2 Question 2: Assume that initially an economy is running a trade surplus and its equilibrium output is below the natural level of output Y n. Suppose that the government would like to increase the equilibrium output to the natural level and at the same time remove the trade surplus to achieve a trade balance. Also assume that the Marshall-Lerner condition holds in this economy. a. Now only consider the equilibrium in the domestic goods market. Draw graphs for the initial equilibrium in the goods market and the corresponding net export curve. Indicate the initial equilibrium output by Y 0 and the initial equilibrium net export by NX 0. b. Suppose that the natural level of output corresponds to a trade deficit in the initial net export curve. Indicate the position of the natural level of output in your graphs drawn in part (a) by Y n B. Please propose a policy mix in terms of government spending and the real exchange rate to achieve the goal set by the government. Illustrate the policy mix in your graphs drawn in part (a). c. Replicate the graphs you drew in part (a) here. Suppose that the natural level of output corresponds to a trade surplus in the initial net export curve. Indicate the position of the natural level of output in your graphs by Y n C. Please propose a policy mix in terms of government spending and the real exchange rate to achieve the goal set by the government. Illustrate the policy mix in your graphs. Suppose that the economy is under a flexible exchange rate regime and that the domestic and foreign price levels are both fixed and set to 1. The expected nominal exchange rate E e does not change and the foreign interest rate is fixed at i. d. What kind of monetary policy is needed to achieve the change of the real exchange rate that you proposed in part (c)? Illustrate your proposed monetary policy together with the fiscal policy derived in part (c) using an IS-LM-UIP diagram (i.e. Mundell-Fleming model) such that output will go to the natural level of output. How would the equilibrium consumption, investment change after the proposed changes in the fiscal and monetary policy are implemented? Suppose that the economy is under a fixed exchange rate regime and the domestic currency is pegged to U.S. Dollar (foreign currency). The domestic and foreign price levels are both fixed and set to 1. The interest rate in the U.S. is fixed at i. Suppose that the expected nominal exchange rate does not change. e. After implementing the fiscal policy that you proposed in part (b), what kind of monetary policy is needed to maintain the fixed exchange rate? Illustrate your proposed monetary policy together with the fiscal policy derived in part (b) using 2

3 an IS-LM-UIP diagram (i.e. Mundell-Fleming model). How would the equilibrium consumption, investment and net export change after the proposed changes in the fiscal and monetary policy are implemented? Solution: a. Diagram is attached. b. Diagram is attached. Real exchange rate depreciation and increase in government spending. c. Diagram is attached. Real exchange rate appreciation and increase in government spending. d. Diagram is attached. Contractionary monetary policy. Consumption will increase and the effect on investment is ambiguous. e. Diagram is attached. Expansionary monetary policy. Consumption will increase, investment will increase, and net export will decrease. Appendix: Diagrams 1. Figure 2-a;Figure 2-b: 3

4 2. Figure 2-c: 4

5 3. Figure 2-d: 4. Figure 2-3: THIS IS THE END OF REVIEW QUESTION 3. 5