Answer Key Testname: HOMEWORK 2

Transcription

1 1) A 2) C 3) A 4) B 5) C 6) D 7) C 8) C 9) A 10) D 11) D 12) C 13) C 14) E 15) A 16) C 17) B 18) D 19) D 20) E 21) A 22) D 23) B 24) D 25) D 26) B 27) B 28) A 29) D 30) A 31) A 32) B 33) E 34) C 35) D 36) D 37) E 38) E 39) E 40) C 41) A 42) B 43) B 44) E 45) A 18

2 46) 47) Rate of Expected Return Rate of Difference Dollar Between Depreciation Dollar and Against Euro Euro Exact Case R$ RE E Deposits Formula

3 48) Exchange Rate Number of Dollars per Price of a Sweater One British Pound in British Pounds Price in Dollars 1 50 $ $ $ $ $ $ $ $ $ $ $ $ $ ) Expected Rate of Dollar Depreciation Against Euro Case RE E R$

4 50) Price of a pair of Exchange Rate American Designer Number of Dollars per Jeans Price in British Pounds one British Pound ) Exchange Rate Price of a Pair of Number of Dollars per American Designer One British Pound Jeans Price in British Pounds

5 52) Expected Rate of Dollar Interest Rate Interest Rate Depreciation for the Dollar for the Euro Against Euro Interest Parity R$ R (E e $/ - E$/ )/ E$/ Condition Holds? No No Yes Yes Yes No Yes 53) The figure explains how the money markets of two countries are linked through the foreign exchange market. The monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The European System of Central Banks (ESCB) can affect the exchange rate by changing the European money supply and interest rate. 22

6 54) An increase in the European money supply will reduce the interest rate on the euro and thus will cause the schedule of the expected euro return expresses in dollars to shift down, causing a reduction in the dollar/euro exchange rate, i.e., an appreciation of the U.S. Dollar. The euro depreciates against the dollar. The U.S. money demand and money supply are not going to be affected, and thus the interest rate in the U.S. will remain the same. 23

7 55) See below. 24

8 56) An increase in the U.S. money supply will cause interest rate to decrease. This should increase investment and possibly consumption of durable goods. The reduction in the interest rate will cause a movement to the left along the schedule depicting the expected euro return expressed in dollar. The result is an increase in E or a depreciation of the dollar. 25

9 57) 58) Expected Rate of Dollar Depreciation Against Euro Case RE E R$ Rate of Return Expected Difference Rate of Between Dollar Euro Dollar Dollar and Interest Interest Depreciation Euro Case Rate, R$ Rate, RE Against Euro Deposits

10 59) An increase in the nominal money supply raises the real money supply, lowering the interest rate in the short run (the movement from 1 to 2 on the lower left figure). The money supply increase is considered to continue in the future, and thus it will affect the exchange rate expectations. This will make the expected return on the euro more desirable and thus the dollar depreciates. In the case of a permanent increase in the U.S. money supply, the dollar depreciates more than under a temporary increase in the money supply (from point 1 to point 2 in the upper left figure). Now, in the long run, (the right hand side figure), prices will rise until the real money balances are the same as before the permanent increase in the money supply (from point 2 to point 4, in the lower right figure). Since the output level is given, the U.S. interest rate which decreased before, will start to increase, until it will move back to its original level 9from Point 2 to 4 in the lower left figure). The equilibrium interest rate must be the same as its original long run value (at point 4 in the lower right figure). This increase in the interest rate must cause the dollar to appreciate against the euro after its sharp depreciation as a result of the permanent increase in the money supply (this process is depicted in the upper right figure from point 2 to 4 ). So a large depreciation (from Point 1 in the left upper figure to pint 2 in both the left and right upper figures) is followed by an appreciation of the dollar (the movement from 2 to point 4 in the upper right hand side figure). Eventually, the dollar depreciates in proportion to the increase in the price level, which in turn increases by the same proportion as the permanent increase in the money supply. Thus, money is neutral, in the sense that it cannot affect in the long run real variables, such as output, investment, etc. Note that points 3 and 4 represent the same exchange rate. 27

11 60) Using the covered interest rate parity will yield the second column in the table: F$/E = (R$ - RE) E$/E + E$/E Todayʹs Dollar/Euro Forward Exchange Rate Exchange Rate E$/E F$/E

12 Answers to Part II, Problem Set 2 1. The household budget constraint can be written as: C 1 + C 2 1+r = Y 1 T 1 + Y 2 T 2 1+r (1) Since Y 1 = Y 2 =10,T 1 = T 2 =1, and r =0.1, this implies: C 1 + C =9( ) (2) But optimal consumption requires that: U/ C 1 U/ C 2 =1+r (3) Here: U/ C 1 = C 1 2, U/ C 2 = β C 2 2, and β =1/1.1, so you obtain Combining (2) and (4) you obtain: The trade balance is: C 1 = C 2 (4) C 1 = C 2 =9 TB t = Y t C t G t =10 9 1=0 This is also the current account balance. 2. There was a typo in this part (Sorry!): the second line should have been "...and, as a consequence, T 2 =(2+r ). " The reason was that, if the government borrows one unit in period 1 (to pay for G 1 ), then in period 2 it has to finance G 2 =1plus principal and interest on what it borrowed in period 2, (1 + r )G 1 =(1+r ). So the necessary tax is 1+(1+r ). Use these facts in the budget constraint (1)to get: C 1 + C (2.1) = = = =9( ) which is the same as (2)! Since the budget constraint is the same and the optimality condition is the same as before (and given by (4)), the solution for C t and the trade balance is also the same. This is an instance of Ricardian Equivalence: see the next question. 1

13 3. If the government borrows and lends at the world interest rate, then its own budget constraint in present value terms must be: G 1 + G 2 1+r = T 1 + T 2 (1 + r ) (5) This means that, given G 1 and G 2, taxes must always satisfy that relationship, no matter how taxes are distributed over time (i.e. no matter how much the government borrows in the first period). To see why, imagine that the government reduces taxes in period 1. Then it has to borrow more in that period, and therefore taxes must increase in period 2 to pay for the debt (plus interest). See the discussion in Schmitt Grohe-Uribe. Now, combine the previous budget constraint with the household s budget constraint (1) to get C 1 + C 2 1+r = Y 1 + Y 2 1+r (G 1 + G 2 1+r ) This equation and 3 can be solved for C 1 and C 2 given Y 1,Y 2,G 1,G 2 and r. Note new that neither T 1 nor T 2 appear in these two equations. This means that the solution for C 1 and C 2 does not depend on taxes (although taxes must satisfy (5)) 4 and 5: These questions are just a matter of replacing the appropriate values, so I leave them up to you. 2