EC202 Macroeconomics Koç University, Summer 2014 by Arhan Ertan Study Questions 4 1. Assume that the LM curve for a small open economy with a floating exchange rate is given by Y = 200r 200 + 2(M/P), while the IS curve is Y = 400 + 3G 2T + 3NX 200r. The function for NX is NX = 200 100e, where e is the exchange rate. The price level (P) is fixed at 1.0. The international interest rate is r * = 2.5 percent. a. Using the LM curve, find the equilibrium level of Y in the small open economy, if M = 100. b. Given this value of Y, if G = 100 and T = 100, what must be the equilibrium value of NX? c. If this value of NX is to be achieved, what must be the equilibrium exchange rate, e? 2. Assume that an economy is governed by the Phillips curve = e 0.5(u 0.06), where = (P P 1 )/P 1, e = ( e P 1 )/P 1, and 0.06 is the natural rate of unemployment. Further assume e = 1. Suppose that, in period zero, = 0.03 and e = 0.03 that is, that the economy is experiencing steady inflation at a 3 percent rate. a. Now assume that the government decides to impose whatever demand is necessary to cut unemployment to 0.04. Suppose the government follows this policy for periods 1 through 5. Create a table of and e for these five periods. b. Assume that, for periods 6 through 10, the government decides to hold unemployment at 0.06. Create another table of and pe for these five periods. Is there any reason to expect the inflation rate to go back to 0.03? c. If the government persisted in its behavior under part a, do you think the public would continue for long forming expectations according to e = 1? Why? 3. Assume that an economy is initially operating at the natural rate of output. Use the model of aggregate demand and aggregate supply (using the upward sloping short run aggregate supply curve) to illustrate graphically the short run and long run effects on price and output of a reduction in government spending that produces a budget surplus. Page 1
4. Assume that an economy is initially at the natural rate of unemployment. a. Use a Phillips curve diagram to illustrate graphically how the inflation rate and unemployment rate respond both in the short run and in the long run to an unexpected expansionary monetary policy. b. Use a Phillips curve diagram to illustrate graphically how the inflation rate and unemployment rate respond both in the short run and in the long run to the announcement of a credible plan of expansionary monetary policy when people have rational expectations. 5. For each of the two models of short run aggregate supply (sticky price and imperfect information) compare the following characteristics: a. the nature of the market imperfection that generates the short run movements in output associated with unexpected movements in the price level; b. whether prices are flexible or fixed; 6. The Phillips curve in Lowland takes the form of = 0.04 0.5 (u 0.05), where is the actual inflation rate and u is the unemployment rate. The Phillips curve in Highland takes the form of = 0.08 0.5 (u 0.05). The current unemployment rate in both countries is 9 percent (0.09). a. Explain the similarities in the Phillips curves in Highland and in Lowland. b. Explain the difference in the Phillips curves in Highland and in Lowland. c. In which country will policymakers face a bigger tradeoff if they try to reduce unemployment in the short run? 7. a. What is the sacrifice ratio? b. What is one factor that could possibly lower the sacrifice ratio for an economy? c. What is one factor that could possibly increase the sacrifice ratio for an economy? 8. Use the aggregate demand aggregate supply model to graphically illustrate the difference between demand pull and cost push inflation. Explain your graphs in words. Page 2
9. Illustrate the short run and long run impact of an unexpected monetary contraction using both the AD AS model and the Phillips curve. Assume the economy starts at full employment. 10. How would an adverse supply shock change the short run tradeoff between inflation and unemployment? Illustrate your answer using a Phillips curve diagram. 11. An economy is initially in equilibrium at the natural level. The central bank increases the money supply. Graphically illustrate and explain short run monetary nonneutrality and long run monetary neutrality using the AD AS model. 12. Suppose the government of a small open economy with a floating exchange rate imposes 50 percent tariffs on all imports. Use the Mundell Fleming model to illustrate graphically the short run impact of the tariffs of the exchange rate and output in the country. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short run equilibrium. 13. a. You are the chief economic adviser in a small open economy with a floating exchange rate system. Your boss, the president of the country, wishes to increase the level of output in the short run in order to win reelection. Do you recommend using expansionary or contractionary monetary or fiscal policy? b. Use the Mundell Fleming model to illustrate graphically your proposed policy. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short run equilibrium. Page 3
14. Economic expansion throughout the rest of the world raises the world interest rate. Use the Mundell Fleming model to illustrate graphically the impact of an increase in the world interest rate on the exchange rate and level of output in a small open economy with a floating exchange rate system. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium levels; iv. the direction the curves shift; and v. the new short run equilibrium. 15. Two small open economies, Fixed and Flex, can be described by the Mundell Fleming model. The countries are otherwise identical except that Fixed maintains a fixed exchange rate, while Flex maintains a flexible exchange rate regime. The governments of both countries increase spending by the same amount. Compare what happens in the two countries to: a. the exchange rate b. equilibrium output c. net exports. 16. Macroland is a small open economy with perfect capital mobility and a flexible exchange rate system. Macroland is initially in equilibrium at the natural level of output with balanced trade. Compare the impact of a tax cut in the short run (when prices are fixed) and in the long run (when prices are flexible) on: (a) output, b) consumption, (c) investment, (d) net exports, and (e) the exchange rate. 17. The government of a small open economy with perfect capital mobility wants to establish a stronger currency by moving its exchange rate higher. Suggest both an appropriate monetary policy adjustment and an appropriate fiscal policy adjustment that would allow the economy to move to a higher exchange rate. What are the consequences of these adjustments on domestic output and net exports? 18. A U.S. Congressman wants to reduce the U.S. trade deficit by imposing tariffs on imports. Use a model of a large open economy with a flexible exchange rate to predict the impact of tariffs on U.S. imports, exports, net exports, the exchange rate, and the interest rate. 19. Explain how net capital outflows change in a large open economy when there is a: a. monetary contraction b. fiscal contraction. Page 4
20. Holding everything else constant, compare the impact of a monetary expansion in a small open economy with a floating exchange rate and in a large open economy with a floating exchange rate on: a. domestic investment b. domestic output 21. During periods of economic downturn, there is frequently pressure to protect domestic production from foreign competition in the belief that protectionist policies will save domestic jobs. Will protectionist policies increase or decrease domestic production in a large open economy with a floating exchange rate, holding all else constant? Illustrate your answer graphically and explain in words. 22. What type of monetary or fiscal policy will generate both a stronger economy (increased Y) and a stronger dollar (increased e) in a large open economy with a floating exchange rate? Explain. 23. The impossible trinity refers to the idea that a country can simultaneously pursue only two of the three following policies: free international capital flows, monetary policy for domestic stabilization, and a fixed exchange rate. For each of the following combinations indicate what the economy gives up by selecting the combination and why the omitted policy cannot be achieved: a. a fixed exchange rate and free international capital flows b. a monetary policy for domestic stabilization and a fixed exchange rate c. a monetary policy for domestic stabilization and free international capital flows Page 5
Answer Key 1. a. Equilibrium Y = 500. b. Equilibrium NX = 166.67. c. Equilibrium e = 1/3. 2. a. Period π e π 1 0.03 0.04 2 0.04 0.05 3 0.05 0.06 4 0.06 0.07 5 0.07 0.08 b. Period π e π 6 0.08 0.08 7 0.08 0.08 8 0.08 0.08 9 0.08 0.08 10 0.08 0.08 There is no reason to expect inflation to fall as long as U = U N. c. After a while, one would not expect the public to be fooled by steadily accelerating inflation. 3. In the short run output and prices decrease. In the long run output increases to restore full employment, but at a lower price level. Page 6
4. a. In the short run, the inflation rate increases to 2 and the unemployment rate falls to u 2. However, in the long run, the Phillips curve shifts upward to the right. The unemployment rate returns to the natural rate, but with a higher rate of inflation than what it was initially. There is a short run tradeoff between inflation and unemployment. b. Since expectations are formed rationally and the policy is credible, the Phillips curve will immediately shift upward to the right. In both the short run and the long run, the inflation rate increases to 2, but the unemployment rate remains at u n. There is no short run tradeoff between inflation and unemployment in the short run or in the long run. 5. a. In the sticky price model the market imperfection exists because not all firms adjust prices instantaneously to changes in demand. In the imperfect information model the market imperfection exists because of temporary misperceptions about prices. b. A proportion of firms in the sticky price model have fixed (sticky) prices. All prices are flexible in the imperfect information model. 6. a. Both countries have a natural rate of unemployment of 5 percent, and the slope of the Phillips curve is the same in both countries. The Phillips curves in both countries indicate a short run tradeoff between more inflation and less unemployment. Page 7
b. The expected rate of inflation is higher in Highland (8 percent) than in Lowland (4 percent). The actual rate of inflation is also higher in Highland (4 percent) than in Lowland (2 percent). c. The policymakers in Highland will face twice the increase in the inflation rate as the policymakers in Lowland when they both attempt to reduce unemployment. For example, to reduce the unemployment rate to 5 percent, the inflation rate will increase from 2 percent to 4 percent in Lowland, but will increase from 4 percent to 8 percent in Highland. It will require a much higher rate of inflation in Highland to achieve the same rate of unemployment as in Lowland. 7. a. The sacrifice ratio is the percentage of a year's real GDP that must be given up to reduce inflation by 1 percent. b. Rational expectations and credible public announcements in advance of policy changes could reduce the sacrifice ratio. c. If hysteresis exists in an economy, causing output loss to continue after the disinflation is over, then the sacrifice ratio will be higher. 8. Starting at long run equilibrium at A, a demand pull inflation would be represented by an increase in the aggregate demand curve from AD 1 to AD 2. The new short run equilibrium at B represents an increase in the price level from P 1 to P 2, and thus an inflation resulting from an increase in demand. A cost push inflation would be represented by a shift in the aggregate supply curve from AS 1 to AS 2. The new short run equilibirum at C represents an increase in the price level from P 1 to P 2, and thus an inflation resulting from an increase in supply. 9. In the AD AS model, the unexpected monetary contraction shifts aggregate demand from AD 1 to AD 2. The new short run equilibrium at B has a lower price level and lower output. In the long run when the lower price level (and lower inflation) become expected, the aggregate supply curve shifts from AS 1 to AS 2 and the long run equilibrium is at the natural level of output at C. Using the Phillips curve, the unexpected monetary contraction reduces the inflation rate in the short run. The lower inflation rate results in a higher unemployment rate at a point like B on the same Phillips curve. In the long run when the lower inflation rate becomes expected the Phillips curve shifts down and the unemployment rate returns to the natural rate at C. Page 8
10. An adverse supply shock ( ) would shift the Phillips curve up from PC 1 to PC 2. The inflation rate at the natural rate of unemployment increases by the amount of the inflation shock. Now a policymaker would face a higher inflation rate associated with every unemployment rate. For example at u 1, the inflation rate now shifts from 1 to 2. Alternatively every inflation rate is now associated with a higher unemployment rate. For example, at 1 the unemployment rate now shifts from u1 to 2. 11. Monetary nonneutrality occurs when changes in money affect real variables. Graphically, this is shown in the short run as the economy moves from A to B. The increase in money increases output, a real variable. This occurs because firms and workers are expecting price level P 1, but the price level rises to P 2. Eventually, workers' expectations of the price level increase, shifting the AS curve up. Monetary neutrality occurs when changes in money affect only nominal variables, not real variables. Graphically, this is depicted in the long run as the economy eventually moves from A to C. The increase in money affects only prices. Page 9
12. 13. a. expansionary monetary policy b. 14. 15. a. The central bank in Fixed will keep the exchange rate fixed, while the exchange rate will increase in Flex. b. Output will increase in Fixed but will be unchanged in Flex. c. Net exports will be unchanged in Fixed (because the exchange rate does not change) but will decrease in Flex (because the exchange rate increased). Page 10
16. a. In both the short run and long run, output is unchanged. b. Consumption is higher in both the short run and the long run because the tax cut increases disposable income. c. Investment is unchanged in the short run and the long run because there is no change in the world interest rate. d. In the short run and long run, net exports decrease by the amount that consumption increases because the exchange rate increases. Starting from balanced trade, the country will have a trade deficit in the short run and the long run. e. In the short run and long run, the exchange rate is higher because the tax cut puts upward pressure on the domestic interest rate, which attracts capital inflows and drives up the exchange rate. 17. Contractionary monetary policy would move the economy to a higher exchange rate. Domestic output would be reduced by the decrease in the money supply, and the higher exchange rate would reduce net exports. Expansionary fiscal policy would also move the economy to the higher exchange rate. The level of domestic output would not change, but the composition of output would change. The higher exchange rate resulting from either more government spending or more consumption spending caused by lower taxes would crowd out net exports. 18. The tariffs reduce the demand for imports, raise the demand for net exports, and cause the exchange rate to appreciate. The higher exchange rate reduces exports by an amount equal to the decrease in imports, so there is no change in net exports or in the trade deficit. Since there is no change in saving or investment, there is no change in the interest rate. 19. a. A monetary contraction increases the domestic interest rate, which will make domestic investment opportunities more attractive and reduce net capital outflows. b. A fiscal contraction decreases the domestic interest rate, which will make domestic investment opportunities less attractive and increase net capital outflows. 20. a. Since the world interest rate does not change, domestic investment will not change in the small open economy, but the domestic interest rate will decrease in the large open economy, which will increase domestic investment. b. The monetary expansion increases domestic output in both economies, but through different pathways. In the small open economy the monetary expansion will reduce the exchange rate, increasing domestic output via an increase in net exports (and induced consumption spending through the increase in income). In the large open, economy, output increases not only because of the increase in net exports, but the monetary expansion also reduces the domestic interest rate and increases domestic investment. Page 11
21. The protectionist policies will not change domestic output. There is no change in net capital outflows, so the IS does not shift in the IS LM model. The protectionist polices shift the NX schedule and result in a higher exchange rate. The reduction in imports generated by the protectionist policies is met with an equal reduction in exports as a result of the higher exchange rate, resulting in no change in net exports or in domestic output. 22. Expansionary fiscal policy raises domestic output and domestic interest rates. The higher domestic interest rates will reduce net capital outflows and increase the exchange rate, thereby generating both stronger output and a stronger exchange rate. 23. a. The economy loses the ability to use monetary policy for domestic stabilization because monetary policy must be used to maintain the fixed exchange rate. b. The economy must restrict the free flow of international capital to isolate the determinants of the domestic interest rate from the world interest rate, so monetary policy can be used to influence the domestic economy and at the same time fix the exchange rate. c. The economy cannot fix the exchange rate because monetary policy is used for domestic stabilization rather than to fix the exchange rate. The free flow of capital ensures that the domestic interest rate is determined by the world interest rate rather than by domestic monetary policy. Page 12