14.02 Principles of Macroeconomics


Problem Set #7

Posted: Wednesday, May 2, 2001

Due Date: Wednesday, May 9, 2001


Please remember to write your TAís name and section time on the front page or your problem set.


Part I: True/False Questions: Decide whether each statement is true or false and justify your answer with a short argument.(5 points each, 50 points total)


1.      The Asian miracle (i.e. the very high average growth rates in East Asia during the last few decades) is mainly due to high investment rates and adoption of foreign technology.

2.      One explanation for the Asian financial crisis was the fact that the affected countries had been borrowing in their own currencies to finance projects whose returns were fixed in foreign currency.

3.      During the last 40 years the US federal budget has been mostly in deficit.

4.      Greenspanís monetary expansion policy in the 1990s overcame the fiscal restraint of the structural tax increase, supporting growth while leading to budget surplus.

5.      Investors should prefer to buy government bonds from countries with the highest nominal interest rate.

6.      In mid 1998, the US yield curve was only slightly upward slopping, i.e., the medium term interest rates were slightly higher than the short term, and the long term interest rates were slightly higher than the medium term.This was consistent with the hypothesis that financial markets expected the Fed to increase short-term interest rates.

7.      During April 2001, the Fed decreased the federal funds interest rate twice, by 0.5 percentage point each time.While the second decrease was not anticipated by the financial markets, the first was less than anticipated.The announcement had the same immediate effect on stock and bond prices.

8.      The rational expectations assumption implies that consumers take into account the effect of future fiscal and monetary policies; therefore, neither policy will have a significant effect on real economic activities.

9.      Since we are running a budget surplus today, the best advice that you would give President Bush to avoid the much-feared recession is to increase government expenditure for retirees.

10.  Alan Greenspan, experiencing a strong influence over the NASDAQ, has no influence on the Japanese and German financial markets.


Part II: Big Mac Question (10 points)

NOTE: see the April 2001 Economist magazine.


What exchange rate (pesos per $) would make the cost of a Big Mac the same in dollars in Chile as in the US?Show your calculation.


Part III: Expansionary Monetary Policy and the Yield Curve (8 points each, 16 points total)

In quiz 2, we examined the effect of a monetary contraction (section 3, part 3).

1.      Draw the path of the nominal interest rate following the money supply contraction under the assumption of a fixed price level.

2.      Suppose that the highest point in the interest rate path is reached after one year and the long run value is reached after three years. Draw the yield curve just after the reduction in the money supply, one year later, and three years later.



Part IV: The 1992 Deficit Reduction Package(8 points each, 24 points total)

During the 1992 US election campaign, the large deficit emerged as a major issue. So, when President Clinton won the election, deficit reduction was one of the first items on the new administrationís agenda.

1.      Give three reasons why the deficit was of a major concern.

2.      What does deficit reduction imply for output in the medium run and long run?

3.      In the final version passed by the Congress in August 1993, the deficit package included a reduction of $20 billion in its first year, increasing gradually to $131 billion four years later. What was the actual budget deficit achieved?