14.02 PRINCIPLES OF MACROECONOMICS, CONFLICT QUIZ 2

Read all questions carefully and completely before beginning the exam.

Show your work on all questions in order to receive partial credit.

The quiz is worth a total of 100 points.

Please use three blue books, one for each question.   Write your name, TA name, and section or recitation time on each book.  Also, return your copy of the quiz to the TA’s when you complete the test.

No notes, calculators, or books may be used during the quiz.

You will have 2 hours to complete the quiz.  Good luck!

QUESTION 1:  TRUE OR FALSE  Explain your answer fully.  28  points (4 pts. each)

1. A recession in a foreign country will lead to a reduction in domestic output and increase in net exports.
2. A currency appreciation will normally cause an immediate increase in net exports.
3. If the trade deficit is zero, the domestic demand for goods and the demand for domestic goods are equal.
4. Suppose that, in an open economy with flexible exchange rates, a government wants to depreciate its currency without changing output.  It can do so with just monetary policy.
5. Under perfect capital mobility, when a country joins a system of fixed exchange rates, it gives up the freedom to choose its interest rate.
6. If the US dollar is expected to depreciate relative to the German mark over the next year, the US interest rate will be higher than the German interest rate.
7. An unexpected monetary contraction will have a greater impact on the current exchange rate if it is expected to last 2 or more years than if it is expected to last only one year.

QUESTION 2: OPEN ECONOMY IS-LM  (42 points total)

Consider the following open economy:

C=20+0.8*(Y-T)

I=30+0.3*Y-20*i

G=T=10

NX=40-0.3*Y-30/E

MD=Y-50*i

MS=295

P=P*=1

Ee=1, i*=0.1; the exchange rate is flexible

1. (3 points) Write down and graph the LM relation.  Explain what it represents and whether there are any differences relative to the closed economy.
2. (4 points) Write down and interpret in words the equilibrium condition of the goods market.  Are there any differences relative to the closed economy?
3. (5 points) Derive the interest parity condition. Explain your derivation. What is the approximate version of the interest parity condition?  Graph the interest parity condition.
4. (5 points) Derive and graph the open economy IS curve (in the Y-i space).  Interpret, and explain any differences relative to the closed economy IS curve.
5. (12 points) Explain the effects of a fiscal contraction using words and graphs (no algebra): what happens to output, the interest rate and the exchange rate?  What happens to investment and net exports?  Answer the same questions for a monetary contraction as well.
6. (7 points) How can the government increase interest rates without changing output?  What will happen to the exchange rate and net exports?
7. (6 points) Can the government achieve higher interest rates without changing output and net exports in our model?  In reality?

QUESTION 3: FIXED EXCHANGE RATES AND THE OPEN ECONOMY  (30 points total)

You are in charge of a small developing country.  The exchange rate is fixed at E* and this level is credible (so Et =Ee t+1 =E*).  The economy is growing “too” rapidly (output is “dangerously” high) and there is also a large foreign pressure to decrease your trade surplus.

1. (10 points) Your first potential policy is a fiscal contraction.  What happens to output, the interest rate and net exports if you use this policy?  Is there any role for the Central Bank?  Explain your answers in words and with IS-LM graphs.  Be clear which curves shift and why.
2. (10 points) A second policy option is to revalue your currency: Et =E*new <E*.  Assume that this new regime remains credible (so Ee t+1 =E*new).  What happens to output, the interest rate and net exports in this case?  Is there any role for the Central Bank?  Explain your answers in words and with IS-LM graphs.  Be clear which curves shift and why.  (Extra 2 points for proving the effect on net exports.)
3. (10 points) Suppose that, before you could have used any of these policies, investors start suspecting a revaluation.  This makes Ee t+1 <E*.  What happens to the interest rate?  Is there a role for the Central Bank there?  What happens to output if interest rates stay at this level for a long time?  What happens if interest rates do not change as much as implied by interest parity (and capital flows are slow, i.e. imperfect capital mobility)?