14.02 PRINCIPLES OF
MACROECONOMICS, CONFLICT QUIZ 2
STOP! READ INSTRUCTIONS FIRST:
Read all questions
carefully and completely before beginning the exam.
Label all of your
graphs, including axes, clearly; if we can’t read the graph, you will lose
points on your answer.
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.
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)
recession in a foreign country will lead to a reduction in domestic output
and increase in net exports.
currency appreciation will normally cause an immediate increase in net
- If the
trade deficit is zero, the domestic demand for goods and the demand for
domestic goods are equal.
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
perfect capital mobility, when a country joins a system of fixed exchange
rates, it gives up the freedom to choose its interest rate.
- 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
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:
Ee=1, i*=0.1; the exchange rate is
points) Write down and graph the LM relation. Explain what it represents and whether there are any
differences relative to the closed economy.
points) Write down and interpret in words the equilibrium condition of the
goods market. Are there any
differences relative to the closed economy?
points) Derive the interest parity condition. Explain your derivation.
What is the approximate version of the interest parity condition? Graph the interest parity condition.
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.
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.
points) How can the government increase interest rates without changing
output? What will happen to the
exchange rate and net exports?
points) Can the government achieve higher interest rates without changing output
and net exports in our model? In
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.
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.
points) A second policy option is to revalue your currency: Et
=E*new <E*. Assume that this new regime remains credible (so Ee
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.)
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)?