Download Document

5 points
1. Use the short-run Keynesian for a small open economy with a floating exchange rate (the
Mundell-Fleming model) to predict what would happen to aggregate real income (Y), the
exchange rate, and the trade balance in response to each of the following shocks:
A. A fall in consumer confidence about the future, which induces consumers to spend less and
save more.
B. A shift in consumer preferences toward environmentally friendly cars; many consumers
turn away from Swedish produced cars (Volvo and SAAB).
C. An increase in the real money supply.
Answer:
A.If consumers decide to spend less and save more, C decreases. Output is unchanged. The
exchange rate depreciates, which causes an increase in the trade balance equal to the fall in
consumption.
B.implies that the NX falls at a given exchange rate. Output does not change, while the
exchange rate depreciates. The trade balance does not change, despite that the exchange rate
has depreciates. We know this since NX=S-I, and both saving and investment remain
unchanged.
C.An increase in money supply decreases interest rate, which leads to capital outflow, a
depreciating currency, the trade balance improves an income increases.
3 points
2. Traveling in Mexico is much cheaper now than it was 10 years ago, says an American
friend. “Because ten years ago, a dollar bought 10 pesos; this year, a dollar buys 15 pesos. Is
your friend right or wrong? Given that total inflation over this period was 25 percent in the
US and 100 percent in Mexico, has it become more or less expensive to travel in Mexico for
Americans? Analyse how the real exchange rate between the Peso and American dollars has
changed.
Answer: Percentage increase in the real exchange rate = percentage increase in the nominal
exchange rate (Peso/USD) + domestic inflation in the US– foreign inflation = 50 % + 25
percent – 100 percent = - 25 percent. The real exchange rate of the dollar visavi the Mexican
peso depreciates by 25 percent. A depreciation of the real exchange rate makes foreign goods
more expensive and domestic goods cheaper. Thus, the friend should be wrong as it now
should be more expensive to travel in Mexico.
4 points
3. The nominal interest rate is 12 percent per year in Canada and 8 percent per year in the
USA. Suppose that the real interest rate is the same in these two countries, and that
purchasing-power parity (The law of one price) holds.
A. Use the Fischer equation, what can you say about expected inflation in Canada and in the
USA?
B. What can you say about the expected change in the exchange rate between the Canadian
dollar and the US dollar?
C. A friend proposes a get-rich-quick scheme: borrow from a US bank at 8 percent, deposit
the money in a Canadian bank at 12 percent, and make a 4 percent profit. What’s wrong with
this scheme? What has your friend forgotten?
Answer:
A. The expected inflation rate is 4 percentage points higher in Canada.
B.The Canadian dollar is expected to depreciate by 4 percent.
C. He does not take the expected depreciation of the Canadian dollar into account. Assume
that he borrows 1 US dollar from an American bank at 8 percent, exchanges it for 1 Canadian
dollar, and puts it in a Canadian bank. At the end of the year he will have 1.12 Canadian
dollars, which then is expected to be worth 1.08 US dollars, which is the amount owed to the
US Bank.
5 points
4. Jack and Jill both obey the two-period model of consumption. Jack earns $200 in the first
period and $200 in the second period. Jill earns nothing in the first period and $420 in the
second period. Both of them can borrow or lend at the interest rate. r?
a. You observe both Jack and Jill consuming $200 in the first period and $200 in the
second period. What is the interest rate r?
b. Suppose the interest rate increases. What will happen to Jack’s consumption in the
first period? To answer this question, you have to recall the expression for the optimal
consumption in the first period: That is the solution, to the problem:
Maximize U  c1  c21 under the restriction: c1 
c2
Y
 Y1  2 .
1 r
1 r
Instruction how to solve this problem: In case of a Cobb-douglas utility function (like the one
above), the share of expenditures on each good equals that good’s preference parameter in the
utility function. For example: If the individual maximizes U ( x, y )  x   y 
subject to the budget constraint: p x  x  p y  y  I
where y= quantity of good y, x=quantity of good x, p x = price of good x. p y = price of good
y. I = income. The optimal demand of x and y are such that:
px  x*
 I
(1   )  I
if   1    x* 
 x* 

px
p x  (   )
I
p y  y*
I

 y* 
 I
p y  (   )
if   1  

y* 
 I
py
c. What will happen to Jill’s consumption in the first period when the interest rate
increases? Is Jill better of or worse of than before the interest rate increases?
Answer:
A. R=10 percent.
B. The rise in interest rates leads Jack to consume less today and more tomorrow. This is
because of the substitution effect: it costs him more to consume today than tomorrow
because of the higher opportunity cost in terms of foregone interest. We know Jack is
better off: at the new interest rate he could still consume 100 dollars in each period, so
the only reason he would change his consumption pattern is if the change makes him
better off.
C. Jill consumes less today while her consumption tomorrow can either rise or fall.
3 points
5. Assume two countries with the same production function: Y=F(A,K,L); this means e.g. that
totalfactorproductivity (A) is the same in the two countries. Moreover, we assume that the
saving rate is the same in the two countries and that the two countries are in their respective
long-run equilibria (steady states) according to the Solow-model. The only difference between
the countries is that they differ with respect to the long-run growth rate of the work-force
L
 n ):
(
L
A. Which country has the highest GDP per capita?
B. If we allow for capital- and labor mobility between these two countries:
(i). Capital (factories) will move from the country with high population growth.
(ii). Workes will move from the country with low population growth.
(iii). There will be no capital mobility between the countries.
(iv). Capital (factories) will mover from the country with a low population growth rate.
Choose one altenative above!
Svar: B. iv
3 poäng
6. Assume that the economy has the following Phillips curve:
   1  0.5(u  0.05)
a. What is the level of the natural rate of unemployment?
b. By how many percentage points must the actual unemployment rate increase for the
inflation rate to be reduce by 5 percentage points.
c. In case inflationary expectations are rational instead of adaptive, is it possible for
inflation to fall without having a rising unemployment? Explain.
2 points
7. Assume that the government sell public telecom company to the private sector. Does such
actions by the government reduce the national debt as it is now measure? Do you think these
actions represent a true reduction in the government’s indebtedness? Explain!