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Department of Economics, University of Toronto
Halina Kalita von dem Hagen
ECO 208Y: MACROECONOMIC THEORY
PROBLEM SET #4
PART I Multiple choice.
Assume SMALL OPEN ECONOMY WITH PERFECT CAPITAL MOBILITY
1.
In a New Classical economy, a well-known decrease in the rate of growth of domestic
credit
(a)
increases domestic inflation rate under any exchange-rate regime
(b)
decreases nominal interest-rate under any exchange-rate regime
(c)
increases real money balances under a flexible exchange rate regime
(d)
decreases foreign reserves under a fixed exchange rate regime
2.
The government passes a new legislation that increase social assistance. In the long run,
(a)
real interest rate increases
(b)
real wages fall
(c)
net exports fall
(d)
foreign reserves fall
3.
In a New Keynesian economy with staggered contracts, devaluation
(a)
decreases consumption in the short run
(b)
decreases employment in the short run
(c)
increases nominal interest rate in the short run
(d)
increases real money supply in the short run
4.
Assume a Classical economy with a fixed exchange rate. A decrease in government
spending accompanied by open-market purchases of government bonds from the public
(a)
decreases the level of foreign reserves
(b)
increases the price level
(c)
decreases net exports
(d)
increases real money demand
5.
If a country unexpectedly imposes import tariffs, its output
(a)
remains unchanged if it is a small economy
(b)
increases if it has a fixed exchange rate
(c)
increases if it has a flexible exchange rate
(d)
none of the above
6.
Assume a small open economy with perfect capital mobility, flexible prices and
flexible exchange rates. Assume also a positively sloped Aggregate Supply curve. In this
economy, an expansionary monetary policy
(a)
(b)
(c)
(d)
7.
8.
leaves the aggregate price level unchanged in the short run but raises it in the
long run
raises the aggregate price level both in the short-run and in the long-run
raises the aggregate price level in the short run but not in the long run
has no impact on the aggregate price level
Assuming positively sloped AS and a fixed exchange rate, a devaluation
(a)
decreases consumption
(b)
decreases prices
(c)
increases net exports
(d)
all of the above
Assume that the Bank of Canada wants to keep the value of the Canadian dollar
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Halina Kalita von dem Hagen
flexible in terms of the US dollar. Relative to a regime in which the exchange rate is
fixed, this will
(a)
reduce the impact on Canadian output of a decrease in the US demand for
Canadian exports
(b)
increase the effectiveness of fiscal policy
(c)
increase the rate of money supply growth in Canada
(d)
increase the nominal interest rate in Canada
9.
Assume a positively-sloped short-run Aggregate Supply. Under the flexible
exchange rate regime, an increase in money supply accomplished through the central
bank’s open market operations will lead to
(a)
a decrease in the level of income and a currency depreciation
(b)
an increase in the level of income and a currency depreciation
(c)
a decrease in the level of income and a currency appreciation
(d)
an increase in the level of income and a currency appreciation
10.
Assume a Classical economy (vertical long-run Aggregate Supply) with a fixed exchange
rate. An increase in government spending financed by the sale of government bonds to
the public
(a)
increases the level of reserves
(b)
decreases the level of reserves
(c)
leaves the level of reserves unchanged
(d)
changes in reserves depend on whether the government bonds were sold to
domestic or to foreign residents
11.
Which of the following will increase the demand for imports:
(a)
depreciation in the real exchange rate
(b)
rise in domestic output
( c)
rise in foreign output
(d )
all of the above
(e)
none of the above
12.
If a New Keynesian economy switches from a flexible to a fixed exchange rate regime, in
the short run
(a)
monetary policy will become more effective
(b)
fiscal policy will become more effective
(c)
both fiscal and monetary policy will become more effective
(d)
both fiscal and monetary policy will become completely ineffective
(e)
none of the above is true
13.
In a small open New Classical economy with a flexible exchange rate and a perfect
capital mobility, an unexpected drop in demand for exports from the domestic country
will
(a)
lower domestic output in the short run
(b)
lower domestic consumption in the short run
( c)
lower imports in the short run
( d)
all of the above
( e)
none of the above
14.
In a small open Classical economy with a fixed exchange rate and perfect capital
mobility, an increase in the world real interest rate will
(a)
increase domestic output
(b)
increase foreign reserves
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(c)
(d)
(e)
Halina Kalita von dem Hagen
decrease foreign reserves
worsen the trade balance
trigger the devaluation of the domestic currency
15.
In a New Keynesian economy with perfectly synchronized contracts, a fixed exchange
rate and perfect capital mobility, an increase in foreign output that happens when
contracts have been signed will
(a)
increase domestic real wages
(b)
increase domestic nominal wages
(c)
increase investment provided investment is independent of output
(d)
increase government spending
(e)
increase real money balances
16.
In a New Keynesian economy with staggered contracts, a flexible exchange rate and
perfect capital mobility, a decrease in exogenous demand for money will lead to
(a)
deterioration in the trade balance
(b)
depreciation of the real exchange rate
(c)
an increase in foreign reserves
(d)
an increase in the Marginal Product of Labour
(e)
a decrease in consumption
17. In a New Classical economy with a fixed exchange rate and perfect capital mobility an
unexpected drop in business confidence that lowers exogenous investment will
(a)
lower the exogenous demand for money
(b)
lower the real wage rate
(c)
lower the real rate of interest
(d)
lower foreign reserves
(e)
lower net exports
18.
In a New Classical economy with a flexible exchange rate and perfect capital mobility a
well-known expansion in the domestic credit component of money supply will lead to
(a)
depreciation in the nominal exchange rate
(b)
depreciation in the real exchange rate
(c)
improvement in the trade balance
(d)
greater consumption
(e)
all of the above
PART II: EVALUATE each of the following statements. Carefully explain your reasoning:
1. The optimal inflation rate always equals to the negative of the real interest rate. This optimal
inflation rate can be always achieved both in the closed and in the open economy by controlling the
rate of monetary growth.
2. Neither a floating nor a fixed exchange rate will insulate a small open economy from changes
in world interest rates. This is true both in the short run (positively sloped Aggregate Supply) and
in the long run (vertical Aggregate Supply).
Guidelines:
a. Illustrate your answers using the IS-LM-BP and the corresponding AD-AS graphs.
b. Assume that every variable was initially identical under both exchange-rate regimes.
Subsequent to a change in world interest rate, compare changes in the following variables
between a flexible and a fixed exchange rate in the short run:
- output
- prices
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-
Halina Kalita von dem Hagen
real interest rate
real wage rate
Net Exports
real money supply
c. Repeat comparisons between a flexible and a fixed exchange-rate regime for variables
as specified in ( c ) above for the long run.
d. Explain carefully all the adjustment mechanisms both for the short-run and for the
long run.
3. A country can have both a stable exchange rate and stable prices if it follows appropriate
monetary policy.
4. The current account balance plus the capital account balance sum to zero always, both under
flexible and fixed exchange rate regimes.
PART III: ANSWER THE FOLLOWING:
1. As a result of the Free Trade Agreement between Mexico and the United States, both Mexico
and the United States have eliminated many import restrictions. Using the IS-LM-BP and AS-AD
framework, discuss the effects of this Agreement on Mexican output, employment, real wages,
consumption, investment, exports and imports, prices, the level of real money balances, the
level of foreign reserves held by Mexico. Carefully explain all adjustment mechanisms.
Consider both the short-run and the long-run effects.
In answering this question assume that at the time when the Agreement was introduced Mexico
was a small open economy with perfect capital mobility and a fixed exchange rate. Assume also
that the Mexican short-run Aggregate Supply could be described by the New Keynesian model
with staggered wage contracts.
2. Consider an open economy currently in long-run equilibrium, operating under a flexible
exchange rate and perfect capital mobility. In this economy, the rate of growth of money
supply unexpectedly increases. Compared to the initial equilibrium, discuss both short-run and
long-run effects of this policy change on:
(a) output and unemployment
(b) nominal and real wages
(c) inflation rate
(d) nominal and real exchange rate
(e) balance of trade
(f) real interest rates
In each case, CLEARLY EXPLAIN (or illustrate with graphs) your reasoning.
3. Consider an open economy with the zero inflation rate, currently in long-run equilibrium,
operating under a fixed exchange rate and perfect capital mobility. There are no contracts in
this economy. The output in the rest of the world unexpectedly rises. Compared to the initial
equilibrium, discuss both short-run and long-run effects of this shock on the following variables
in the home country:
(a) output and unemployment
(b) real exchange rate
(c) balance of trade
(d) level of foreign reserves
In each case, CLEARLY EXPLAIN (or illustrate with graphs) your reasoning.
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