14.02 Problem Set 7 - Solutions
Part I: True/False
(5 points each, 50 points total)
1. True. Rather than being truly 'miraculous',
countries like Singapore and Taiwan were able to grow at very high rates for
many years because they invested a tremendous amount of their income each year,
and were able to adopt pre-existing technology rather than re-inventing
2. False. The Asian crisis was characterized by a
sharp depreciation of Asian currencies.
If firms' debt was in domestic currency and revenue was in foreign
currency, this would increase revenue relative to debt, helping the firms. In fact, many firms had borrowed in foreign
currency (foreign lenders would rather not face any currency risk), but had
revenue in domestic currency. When the
domestic currency depreciated, they became unable to pay off their debt and
were forced into bankruptcy.
3. True. See lecture slides (Fiscal Policy in the
4. True. See lecture slides (Fiscal Policy in the
5. False. Investors care about the real return they
receive and usually wish to consume in domestic currency, so they must also
consider the expected inflation and exchange rates. Additionally, investors are risk averse, and must worry about the
risk of sovereign default: the foreign government may refuse to pay
6. False. Because the risk of holding a bond rises
with time, we would expect the yield curve to be upward sloping even in the
absence of any expected interest rate changes.
Thus a yield curve that is only slightly upward sloping is consistent
with no expected changes in the interest rate, or possibly an expected future
decrease in short-term interest rates.
7. False. If investors did not anticipate an interest
rate cut, they set stock prices too low, thus the stock market should rise when
the Fed acts. Conversely, if investors
were expecting interest rates to be lower than they actually turned out to be,
stock prices will be too high. Thus the
immediate effects of both announcements could not have been the same - the
effect on stock prices should be in opposite directions. (See page 298 of the text.)
8. True or False. The statement is true since consumers can
act to undo the future monetary and fiscal policy, for example by decreasing
their private savings when the government raises its savings. (Perhaps even more clearly, when the Fed
increases the money supply firms could raise prices immediately, keeping the
real money supply, and thus output, constant).
However, the statement is false to the extent that completely rational
consumers are not able to predict future policy. If the government announces that it will balance its budget next
year, but then doesn't, the consumers may not immediately observe the change in
policy or be able to change their behavior immediately to undo the change.
9. False. This may not be the BEST advice to give
President Bush. There are other ways
that the federal government could increase current spending to boost output
that would also have additional positive long-run effects, like investment tax
credits or spending on education.
10. False. American, Japanese, and German stocks and
bonds are substitutes for one another.
A change in the return on American financial assets will affect the
investment decisions of all investors and will result in changes in foreign
Part II: Big Mac Question (10 points)
of BIG MAC in US: 2.54.
of BIG MAC in Chile: 1260 pesos.
rate should be 1260/2.54 = 496 pesos/dollar.
Part III: Expansionary Monetary Policy and the Yield
Curve (8 points each, 16 points total)
NOTE: This question was updated via email. Here is the answer to the updated version
(changes are in red/underlined).
In quiz 2, we examined the
effect of a monetary contraction (section 3, part 3).
the path of the nominal interest rate following the money supply contraction
under the assumption of
a fixed price level.
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.
Two effects are in motion
that determine the slope of the yield curve.
First, the financial market requires a risk premium for bonds of higher
maturity, therefore, the yield curve tends to be upward sloping. Second, when interest rates are expected to
decrease, then the yield curve tends to be flatter and maybe even downward
sloping for some maturities (as shown above).
See also Blanchard, page 292.
In the above graphs, I
assumed that the second effect dominates for the first curve (which does not
need to be the case, but the curve must at least be flatter than the original
and long run curve). After one year, I assumed that the second effect
dominates, while in the long run, only the first effect is at work.
Part IV: Budget
Deficits (8 points each, 24 total)
1. Here are three classical reasons why budget deficits are
increase the level of government debt, adding to interest rate payments in the
keep interest rates high, and therefore decrease investment.
they are accompanied by a current account deficit (twin deficits), with an associated
loss of competitiveness.
Note that other possible
answers are acceptable here, as longs as they are reasonable and refer to the
economic (rather than ideological) costs of a deficit.
2. In the short run, getting rid of the deficit means a decrease in
output (contractionary fiscal
policy). In the long run, it will imply
higher growth rate if we assume that higher investment brings along higher
budget deficit achieved was eventually negative (a surplus!!), thanks to the
extra taxes collected from the booming stock market.