# 14.02 PROBLEM SET 4 – PRINCIPLES OF MACROECONOMICS(70 points)

Posted Wednesday, 10-11-00

Due Wednesday, 10-18-00

QUESTION 1:  TRUE OR FALSE?   Explain your answer. (15 pts total, 3 points each)

a.                   In a world with only two countries, both can have a trade deficit in the same period.

b.                  If the nominal exchange rate, E, between the US and France falls, holding all else constant, it is more attractive for French tourists to visit the US on vacation.

c.                   When the nominal exchange rate, E, between the US and Finland changes, the real exchange rate, e, always changes too.

d.                  The US finances its trade deficit by increasing its holdings of foreign assets.

e.                   You are considering buying bonds.  The interest rate in the US is 5%, the interest rate in Canada is 6%, and the exchange rate, Et, is 1 (one) at the time of purchase.  Given this information, you should definitely buy Canadian bonds.

QUESTION 2:  DYNAMICS IN THE IS-LM MODEL  (16 points)

Consider the following economy:

Zt = Ct  +  It  + Gt-1

Ct  = 50 + 0.75[0.5(Yt –Tt) + 0.5(Yt-1 –Tt-1)]

It = 50- 120it

Gt-1 = 50

Tt = 50

Mdt = (PtYt/ 3) – 100it

Mst = 75

YDt-1 = (Yt-1 – Tt-1) =  (311 ½ - 50) = 261 ½

Pt = Pt-1  = 1

a.       (8 points)  What is the goods market equilibrium condition?  What is the financial market equilibrium condition?  Find the values of Yt and it in equilibrium.  Graph your answer.  (Note: your answers will not be whole numbers.)

b.      (4 points)  Government spending in this economy is controlled completely by the president, who is up for re-election.  Her advisors tell her that if she can boost disposable incomes, she will win the election.  Therefore, she raises Gt by 15 a few days before the election.  To her dismay, she loses the election.  Why does her plan fail (assuming her advisors were right)?  What happens to Yt ?  Explain.

c.       (4 points) The new president is inaugurated in period “t+1”, and has the power to appoint the chairman of the Central Bank.  Due to the policy of the previous administration, the new president is concerned that interest rates in the economy are too high.  Realizing that her job may be in jeopardy, the Central Bank chair takes measures to increase her popularity with the president.  Within the period (i.e. within “t+1”) she is reappointed to her post.  What did she do to re-gain popularity?  What happened to output when she took this action?  How is this different from what happened in part (b), i.e. why was she successful when the old president was not?  Explain.

QUESTION 3:  EXCHANGE RATES  (19 points)

a.   (3 points)  Imagine a world economy that consists of 2 countries, the US and Esperanza.  (Think of the US as the “home” or “domestic” economy.)  \$600 will buy you 150 kontantos   or K150 –  which is the currency unit of Esperanza.   What is the nominal exchange rate, E?  What happens to E when the dollar appreciates?  What happens to E when the kontanto depreciates?

b.      (4 points)  In the same year, nominal GDP in the US is \$1000, and real US GDP is \$800.  Nominal GDP in Esperanza is K50, and real Esperanza GDP is K60.  What is the real exchange rate, e?  What happens to the real exchange rate if nominal GDP in Esperanza is K80?  What happens if it now costs \$500 to buy K150?

c.       (6 points)  Return to the original assumptions of part (a).  If a US bond pays 5% interest, the current nominal exchange rate is given from part (a), and the expected nominal exchange rate at the end of the period is 3, what must the interest rate be in Esperanza?  What will the Esperanza rate be if the US interest rate falls to 4%?  If the expected nominal exchange rate at the end of the period is 2?  Why do you always know the return on Esperanza bonds if you know E, expected E at the end of the period, and i in the US?  (Hint:  Think about what it would mean if i*, the Esperanza interest rate, could not always be calculated this way.  Could investors take advantage of this?)

d.      (6 points)  Now assume the world has 3 countries.  The US does ¾ of its imports and exports with Esperanza, and ¼ of its imports and exports with the third country, Monolando.  Consider the following assumptions:

\$500 buys M100 monos, the currency of Monolando,

The GDP deflator for the US is 1;

Nominal GDP in Esperanza  = K800,

Real GDP in Esperanza = K600,

Nominal GDP in Monolando = M500,

Real GDP in Monolando = M400.

What is the multilateral real exchange rate for the US?

If it now costs \$400 to buy K100, what happens to the multilateral real exchange rate?  What if it costs \$400 to buy M100?  Are your answers different depending on which nominal exchange rate moves?  Why or why not?

QUESTION 4:  THE GOODS MARKET IN AN OPEN ECONOMY  (20 points)

Consider the following closed economy:

Z = C + I + G

C = 50 + 0.6(Y-T)

I = 40 – 120r + 0.2Y

G = 60

T = 60

r = 0.5, ( where r is the interest rate, as in Blanchard’s ch. 18)

a.       (4 points)  What is the equilibrium level of output in the economy?  What is the multiplier?  What is the level of autonomous spending?  Graph domestic aggregate demand (DD) in the goods market.

Now assume the economy opens up to trade with a foreign country, where foreign variables are denoted with a (*), and the exchange rate is fixed:

Z = C + I + G - eQ + X

C, I, G, T, and r as above

e = 1

Q =  (1/5)Y

X =  (1/6)Y*

Y* = 324

b.      (6 points) What is the equilibrium level of output in the open economy?  What is the multiplier?  What is autonomous spending?  Graph aggregate demand (ZZ) in the open economy model and compare it to domestic demand from (a).  What is the value of net exports?  Is the country running a trade surplus or deficit?

c.       (5 points)  The government of the home country wants to use fiscal policy to boost output, and raises G from 60 to 70.  What is the new equilibrium level of Y in the closed economy?  What is the new equilibrium level of Y in the open economy?  What explains the difference, if any, between the effects of fiscal policy in the closed vs. the open economy?  What happens to the trade balance in the open economy scenario?  Explain.

d.      (5 points)   Now return to the assumptions of parts (a) and (b) – that is, G is fixed at 60.  Imagine that the foreign government executes fiscal policy, raising G* such that Y* is now 384.  What happens to Y in the closed economy?  What happens to Y in the open economy?  What happens to the trade balance in the open economy relative to parts (b) and (c)?  Explain.