QUIZ #2 (Suggested Solution): Fall 1997 (11/18/97)

Please note that the suggested solution provides answer guideline as well as comments on some of the responses we found in your exams. We do not expect you to address all aspects of the answer in order to get full credit.

Part A: TRUE, FALSE, UNCERTAIN (Explain) (30 points)
Answer any 6 of 8 questions
[Note: each question worths five points. If you answered more than six questions, we graded only the first six in the order that you answered them.]

Using the interest rate parity condition, we know that, ignoring transactions cost and assuming risk neutrality, on average the return on bonds in two countries should be equivalent after taking into account of differential in interest rates and market's expected depreciation rate of currency. Under fixed exchange rate regime, Hong Kong dollar is fixed to the US dollar. In usual cases where there is no specualtion against HK dollar, the fixed regime is credible, so expected future exchange rate equal to the current fixed rate, yielding the well known result that i = i*. However, in this case, HK interest rate is substantially higher than US interest rate, implying there is belief among investors that, due to recent financial crisis in Asia as well as slowdown in Hong Kong economy, HK Central Bank might not be able to maintain its fixed exchange rate in the near future. As a result, the Central Bank has to raise interst rate to compensate for devaluation risk if HK bonds is to be held by investors. Therefore, just because HK bonds yield higher interest rate is not enough to make it a better investment than US bonds. It all depends on how you perceive the devaluation risk, and whether current interest rate differential is enough to compensate you to hold that risk.

Some of you pointed out of the distinction between real and nominal return. Actaully, it is not relevant in this context. To compare two investments, you must compare return in the same currency, and thus the exchange rate risk comes in.

Question 2. FALSE
The delay of the effect of real depreciation on net exports in the US during 1985-1987 is a manifestation of the J-curve effect. The weaker dollar, or the nominal depreciation of the US dollar against its major trading partners, had in effect resulted in real depreciation of US goods and services, making them relatively cheaper compared to the imports. [Note that the rate of changes in price level in the US and other major partners during that period was not substantial enough to cause net real appreciation of US goods] This real depreciation will eventually lead to more demand for US exports, and lower demand for imports. Thus, in the long run, US trade balance should improve, as suggested by the Marshall-Lerner Condition. However, in the short run, the effect of import price increase would dominate the volume effects on changes in export and import volumes. As a result, initially weaker dollar or real depreciation did lead to worsening trade balance. But by the end of 1987, the US trade balance did show sign of improvement.

Some of you mentioned other factors that might come into play. For example, some claimed that US expansionary fiscal policy during 1980's caused higher output, and thus increased demand for import, causing the lower net export position. We did recognize this factor as a real possibility, and did give a partial credit for it. Still, to receive full credit, you need to mention the J curve effect, and the M-L condition.

Question 3. FALSE
Using the AS-AD model we get the following results:

Expansionary monetary policy
Short Run Effects: Increase in output, decrease in the interest rate.
Long Run Effects: Assuming that in the initial equilibrium Y=Yn, then the increase in output over its natural value increases demand for employment, increasing wages and then prices. Prices keep moving up until the long run equilibrium in which prices are higher, Y=Yn, interest rate returns to its initial level (because real money balances remain unchanged in the long run) and composition of output remains unchanged when compared with the initial situation before the monetary expansion.
This is neutrality of money (please realize that neutrality does not mean that prices don't change in the long run, it means that real variables don't change in the long run).

Expansionary fiscal policy
Short run effects: Increase in output and increase in the interest rate.
Long Run Effects: Assuming that in the initial equilibrium Y=Yn, then the increase in output over its natural value increases demand for employment, increasing wages and then prices. Prices keep moving up until the long run equilibrium in which prices are higher, Y=Yn.
Real money balances are decreasing during the adjustment period, this implies even higher interest rates to clear the money market. In the long run real money balances are lower, which implies a higher interest rate in the long run equilibrium.
Also, composition of output is different in the long run. In the long run, investment is crowding out 1 by 1 by the increase in G. Investment decrease is equal to government expansion. Consumption remains the same.

Question 4. FALSE
Basically there can be two cases. If initially unemployment is above the natural rate, employment could be increased by increasing the quantity of money in the economy. Of course it will be an effect on prices moving up, but monetary policy can help the economy to reach the natural level of unemployment faster.

But if the economy is initially in Yn, expansionary monetary policy will increase employment only in the short run, in the long run it will only get higher prices (this is neutrality of money again). Note that if initially unemployment was above its natural level and monetary expansion is used to get to that level faster, once this level is obtained there wont't be any reason to keep using monetary policy.

This question has two parts. First, the reason why France has lost its monetary policy is due to the bands system of exchange rates in the European Community. Under narrow bands, the central bank of France has committed to certain level of interest rate, thus French central bank has no control over the monetary base and doesn't have the ability to use an independent monetary policy. On this point, it is not relevant to the US, since the US has a flexible exchange rate regime.

Second, for the case of the US even if the country has a flexible rate system, the effectiveness of the monetary policy is reduced in the open economy, due to the smaller size of the multiplier. Also, higher trade with respect to GDP makes coordination of policies among countries even more important.

Question 6. FALSE
An increase in the minimum wage will improve workers' bargaining position and will, everything else equal, lead to a higher wage. In our wage equation, we capture this as an increase in z. ( Since it is an increase in the cost of labour it does not enter the markup mu, as many of you suggested!) So, for every u and expected p we get a higher wage, the WS relation in the p/w, u graph shifts out. Needless to say, we therefore end up with a higher natural rate of unemployment. If left alone the economy will converge there over time: The AS curve wanders towards the new equilibrium.

Demand could be changed, i.e. by raising G. However, demand shocks, represented by an outward shift of the AD curve, have only temporary effects on output. The induced price surprises will make the AS curve wander upwards again, in the long run the economy will converge to the output level induced by the new natural rate of unemployment, coming with even higher prices.

Question 7. FALSE
Neither a permanent shift in monetary nor in fiscal policy have any permanent effect on output in the long run. Following a positive shock, the economy will return to its natural level of output, leading to higher prices in the case of monetary policy and higher prices and interest rates in the case of an increase in G. The natural rate of output, and therefore unemployment, is determined by the labour market equations only and does not depend on the composition of demand.

If the Central Bank or the Government try to surprise people with new permanent increases in M or P every period, they can, at the cost of a new level of inflation, decrease u as long as people allow themselves to be surprised, i.e. stick to expecting today's price level for tomorrow ( Phillips curve). However, this won't work in the long run, as consumers will change their expectation rule (Expectation Augmented Phillips curve). Deviations from the natural rate of unemployment can be obtained only at the cost of increased inflation rates, leading in the long run to hyperinflations. However, to obtain full credit, only one permanent policy shift had to be discussed.

Speculative attacks occur when investors believe a change in the exchange rate is imminent. To satisfy the IPC, i = i* + (E(exp) -E) / E, i has to be increased in case of an expected devaluation and decreased in case of an expected revaluation. Intuitively, the investors will want to borrow in the local currency today, exchange it for foreign currency, ( therefore exerting a strong downward pressure on the exchange rate today) invest it there and change it back at a more favourable rate in the future to meet their obligations. Raising the interest rate increases the cost of this trade, dissuading investors and relieving pressure on the Forex market.


So, raising i is the principal, but not always an effective means of fighting speculative attacks.

[Note:each question worths six points.]

Under flexible XR regime:
Spending cut in Germany causes its IS curve to shift to the left, which leads to lower i, lower y. The components of its output: G and C and are down, I is ambiguous, NX is up due to the depreciation of Mark (Marshall-lerner condition).

According to interest rate parity, lower interest rate in Germany leads to the depreciation of D Mark and the appreciation of French Franc. (E= DM/Franc is up or E= Franc/DM is down).

Because of the fiscal contraction in Germany, NX of France to Germany is down. French economy then is adversely affected by the slowdown in German economy. IS curve in France moves to the left. Its interest rate is lower, Y is lower, C is lower, I is ambiguous and NX is lower.

Under fixed XR regime:
Under fixed XR, France has to set its interest rate equal to Geman interest rate. As German's interest rate is lower, France has to expand its money supply to lower its interest rate as well. Therefore, its LM curve shifts to the right.

However, we know that France's IS curve also shifts to the left due to the lower NX to Germany. The net effect on Y, C, and I are ambiguous. The NX is lower because of the lower demand in Germany.

(c). A tax cut is an expansionary fiscal policy, disposable income increases, and so do consumption, output and interest rates, through the usual channels. The IS curve shifts to the right.

Since the Bundesbank wants to keep output constant, it will reduce the monetary supply (contractionary monetary policy) and the LM will shift upwards. The result is higher interest rates in Germany and output unchanged. However, the German mark will not appreciate. Why?

Since France and Germany are in a fixed exchange regime, the Central Bank of France will also have to reduce its money suypply in order to raise interest rates in France. Remember that the IPC with a fixed exchange rate is i=i*.

Failure by the Central Bank to intervene would imply either that there are capital outflows from France to Germany, and a loss in reserves to keep the exchange rate fixed, or a switch towards a flexible exchange regime, allowing the DM to appreciate vs. the franc.

Impact on the German economy and composition of output:
Output remains the same but interest rates are higher. Consumption increases: given the income level, disposable income is higher (taxes are lower). Investment is lower: given the income level, interest rates are higher. Government spending is unchanged. Exports are unchanged, the exchange rate remains fixed. Imports are the same, E is fixed and Y is unchanged. Therefore, no change in net exports.

Impact on the French economy and composition of output:
The increase in interest rates reduces investment, and output. Consumption goes down because income is lower. Government spending is unchanged. Exports are unchanged, the exchange rate remains fixed. Under normal circumstances, imports, and therefore net exports, would be lower, E is fixed and Y is lower, but since this is a two-country world, German exports are France's imports, since German exports only depend on E, French imports will have to be independent of French output; imports do not change. Therefore, no change in net exports.

1) It does not make much sense that Germany reduces its interest rates to avoid the appreciation, this would affect the output level which is supposed to remain constant.
2) To raise interest rates in France, we need monetary policy, fiscal policy cannot keep i_f=i_g, it's too slow.
3) The French intervention is instantaneous, i=i* must be kept at all times, so you don't have a DM appreciation and a subsequent contractionary monetary policy in France. The intervention is so that there is no appreciation of the DM vs. the Franc.

(d). The usual combination of policies for this situation would be expansionary fiscal policy, raising output but worsening the trade balance (imports go up), and a DEVALUATION, which would also increase output and improve the trade balance (if Marshall Lerner condition holds).

A fiscal expansion and a monetary expansion which keep the same interest rate, would imply that output is higher, therefore higher imports, while exports are unchanged (at least in the short run), so net exports would go down.

Now, in this very particular case, it turns out that because it's a two-country world and because German exports only depend on the exchange rate, to be consistent, French imports will only depend on the exchange rate. Therefore, fiscal and accommodating monetary supposed to remain constant.

Coordination of policies is a possible answer, but you must explain it well and realize that Germany may not have much of an incentive to engage in it.

1) For countries which have a fixed exchange regime, DEVALUATION/REVALUATION is always a valid policy option for the government. Abandoning the exchange regime and letting float the currency is another one.
2) If you just answer fiscal expansion and monetary expansion with the same interest rate, you only got partial credit. If you noticed that net exports is not generally unchanged, then you got some more. If, in addition, you explained the peculiarities of this case, you got full credit.

(e). This is the application of IS relation in the open economy:

NX = S +(T-G) - I

WIth trade deficit in France, all we can conclude is that France's total saving is lower than its investment level, and that the opposite is true for Germany. However, we cannot make any reference to comparison of the total saving in France and Germany.

Some of you discussed in detail how capital account relates to the trade deficit in this IS relationship. Current/capital accounts are just accounting identities and are irrelevent to the question here. Some of you even interpreted I as the German investment in France, which is not true. Every variable in the IS equation is domestic variable (French net export to outside world = French private saving + French public saving - French investment in their domestic economy).

[Note: each question worths six points]

a. In order to find the natural rate of unemployment, have to make P=Pe. Then us e wage setting (WS) and price setting (PS) equations and solve for u. Will find u=A-1/(1+mu)

b. increase in bargaining power: A is higher. For every possible rate of unemplo yment workers can get a higher wage. Equivalent to a shift of WS to the right. T hus un increases. decrease in markup: equivalent to decrease in mu. The PS shifts upwards. Then th e natural rate of unemployment goes down.

c. If the natural rate of unemployment goes down, then the natural level of out put goes up. This implies that in the long run will end up at a higher output le vel than before (teh new natural level of output). In the short run, output will increase but not as much. The AS curve will shift to the right, enough for y to be equal to new natural level when price is equal to expected price. Given that output is smaller than new natural level, price is lower than expected and then the AS curve keeps shifting down. In the end it shifts enough to intersect AD a t the new yn value.

d. This shock is not going to affect the Natural Rate of Unemployment (NRU). From Chapter 15, recall that the NRU comes from the equality: F(u,z)=1/(1+m), where m is the mark-up. In our expamle it comes from the equality: A-u=1/(1+m). So this is going to shift the short-run AS curve up (or to the left). This will increase prices and decrease output. Why?. Because the increase in the expected price will make workers ask for higher wages making firms increase prices and reduce production.

In the long-run, the fact that unemployment is higher that the natural rate of unemployment will make firms able to hire workers at a lower wages, reducing prices and increasing output, until the economy returns to the NRU. This means that the short-run AS will shift back to its original position (down or right).

One possibility beyond the scope of the material given for this exam is: the expectations of higher prices tomorrow will make consumption today more attractive than consumption tomorrow, therefore consumption increase shifting AD right (or up). However, you still have the movement of the AS explained before and also, tomorrow consumption will fall, so AD will shift back tomorrow and still you need to reach the NRU. Some partial credit were given to answers related to the argument above, however full credit was given only when you gave an answer consistent with THE WHOLE ARGUMENT.

(1) IS-LM: The increase in government expenditure, shifts the IS curve right. This will produce an increase in output and in interest rates.
(2) AS-AD: The shift in the IS curve will imply a shift up of the AD curve, the final equilibrium will imply higher output and higher prices.
(3) IS-LM: The increase in prices will shift up (or left) the LM curve, increasing even more the interest rates. However, output is still higher than before the increase in government expenditure.

In words: Increase in government expenditure will mean an increase in demand this will be covered by increases in production and prices. The fact that the demand for money is higher (higher output) and the real stock of money is lower (higher prices) will imply an increase in interest rates.

Final outcome: higher output, higher interest rates, higher consumption, higher government expenditure, uncertain investment and higher prices.

(1) AS-AD: Since the NRU hasn't changed, and unemployment is lower (output is higher) this will push workers to ask for higher wages. Firms will react to that increasing prices and reducing output. Therefore the short-run AS curve will shift left until the economy reaches the NRU.
(2) IS-LM: The increase in prices will reduce the real stock of money and therefore, will imply higher interest rates, until we get back to the Natural Level of Output, with higher interest rates.

In words: The workers' behavior explained before, will increase prices and reduce output. This will reduce the real stock of money, and even though output is reducing, we will need higher interest ratesbecasue of the lower stock of money (only in extreme cases this will not happen, example: flat IS). The increase in interest rate implies that the part of demand that is being reduced is investment.

Final outcome: output return to is natural level, prices are even higher that in the short-run, interest rates are also even higher that in the short-run, consumption returns to its pre-policy level, investment is reduced and government expenditure is higher that its pre-policy level.

Updated 18-Nov-97 at 17:00 EDT by ythai@mit.edu