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Economics 102 Introductory Macroeconomics
Spring 2006, Professor J. Wissink
Problem Set 7 - ANSWERS
1. True or False (could you explain your decision?):
a. TRUE: According to the Keynesians, unemployment persists because wages are sticky in the
downward direction.
b. TRUE: A weak dollar in international currency markets may increase inflation.
c. FALSE: If the Fed accommodates an increase in inflation, then the rate of growth in the money
supply is negative.
d. FALSE: Comparative advantage of a country in terms of producing a good implies that the country
is able to produce this good with fewer resources than the other country.
e. FALSE: If the United States is a relatively capital abundant country, the Heckscher-Ohlin theory
predicts that the United States will import capital intensive good from overseas.
f. FALSE: If the Fed wants the dollar to depreciate against the Japanese yen, a policy that is consistent
with this goal would be for the Fed to jack up the discount rate.
2. Explain how the following situations affect the United States' Balance of Payments. That is describe
what components of the current and or capital account are changed and in what way.
NOTE FOR ANSWERS LET’S ALWAYS ASSUME THE AMOUNT IS $5,000
a. A U.S. marketing firm designs an ad campaign for a company in France.
Current Account gets +$5000 in “Exports of services” and Capital Account gets -$5000 in “Change
in U.S. assets abroad.”
b. The Cornell Investment Club decides to buy 100 shares of a promising Korean automobile
manufacturer.
Capital Account gets -$5000 in “Change in U.S. assets abroad” and Capital Account gets +$5000 in
“Change in foreign assets in the United States.”
c. A consortium of European investors decides to build a large manufacturing facility in Montana.
Capital Account gets +$5000 in “Change in foreign assets in the United States” and Capital Account
gets -$5000 “Change in U.S. assets abroad” because now some Americans own foreign currency
due to the fact that the European investors sell their Euros in exchange for the dollars they need to
build the facility.
d. You are from India and you and your parents decide to send you to Cornell.
Current Account gets +$5000 in “Exports of services” and Capital Account gets -$5000 in “Change
in U.S. assets abroad.”
3. Identify whether each of the following would lead to an appreciation or depreciation of the dollar. In
each case, explain why the currency either appreciates or depreciates.
a. U.S. citizens switch from buying stock in British companies to buying stock in U.S. companies.
Demand for pounds would decrease  dollar appreciates.
b. The inflation rate in the United States increases relative to the inflation rate in England.
Demand for pounds increases AND supply of pounds decreases  dollar depreciates.
c. The money supply is increased in the United States.
Assume flexible exchange rates and no inflation: then MSup  r down  I up  Y* up (with, of
course, some countervailing feedback due to money demand shifting out). Y* up  imports up
some since consumption is up  and increase in the demand for foreign exchange. More
importantly, since r down  an increase in demand for foreign exchange and a decrease in supply of
foreign exchange as investment looks better outside of the U.S.  the dollar depreciates.
d. Income in the United States increases.
This depreciates the dollar because as the economy enters into an expansion imports rise, hence the
demand of foreign exchange increases  a weaker dollar.
4. Suppose an economy is represented by the equations below:
a.
b.
c.
d.
Find Y* for this economy.
Find the value of the government multiplier.
What is the value of this economy’s current account in its balance of payments?
Without using any explicit numbers, how would a sudden depreciation of the dollar alter Y*?
C = 300 + 0.6Yd
I = 400
G = 1,000
EX = 400
IM = 0.1Yd
Yd = Y-T
T = 1,000
Ans:
a. AEd = C+ I + G + EX – IM
= 300 + 0.6(Y- 1000) + 400 + 1000 + 400 – 0.1(Y – 1000)
= 1600 + 0.5Y
Invoke the equilibrium condition: Y* = AEd  Y* = 1600 + 0.5Y*
0.5Y* = 1600
Y* = 3200
The equilibrium national income, Y* for this economy is 3,200.
b. The government multiplier, Kg
1
1  mpc  mpm
1
=
1  0.6  0.1
1
2
=
0.5
=
c. The economy’s current account is defined as exports – imports of goods and services.
At Y* = 3200, the value of imports is 0.1*[3200-1000] = 220.
Hence, value of current account
= 400 – 220 = 180.
There is a trade surplus.
d. Assume that this economy is the US economy. A depreciation of the dollar implies that the value
of the dollar has fallen. Therefore the price of US exports to other countries will be relatively
cheaper, and the price of imports from other countries to the US will be relatively more
expensive. Therefore, the demand for US exports will increase, while the US demand for imports
will decrease, and therefore the trade surplus will increase as we export more and import less.
This will then cause AEd to increase, which will increase Y*.
5. During 1981 and 1982, the president and the Congress were pursuing a very expansionary fiscal
policy. In 1980 and 1981, the Federal Reserve was pursuing a very restrictive monetary policy in an
attempt to rid the economy of inflation. Ultimately, the economy went into a deep recession, but before
it did, interest rates went to record levels.
a. Explain how this policy mix led to very high interest rates.
b. Show graphically the effect of the high interest rates on the foreign exchange market. What do you
think would happen to the value of the dollar under these circumstances?
c. What impact was such a series of events likely to have on the trade balances in countries like Japan?
Ans:
a. The expansionary fiscal policy increased incomes and the demand for money. This in itself
would cause U.S. interest rates to rise. In addition, the contractionary monetary policy caused
interest rates to rise further.
b. The US demand for foreign exchange would fall, i.e., shift to the left while the supply of foreign
currency would rise, i.e., shift to the right. The value of the dollar would rise, i.e., appreciate.
c. The rise in the value of the dollar (with no other change in the desire to buy more imports or
exports) would make U.S. goods relatively more expensive. The U.S. trade deficit would
worsen, and the trade balance of other countries with the United States would rise.
6.
a.
b.
c.
d.
e.
The statement, “Inflation as a pure monetary phenomenon,” implies that
the Fed can never lower inflation by decreasing the rate of growth in the money supply.
inflation results because of cheaper imports.
inflation increases the value of the nation’s money supply.
the Fed has always liked inflation.
none of the above.
7. Suppose the dollar has been falling in value for more than 18 months against major currencies in the
world. If the Fed increases the money supply to accommodate a growth in output
a. it is following a contractionary monetary policy.
b. it is not accommodation inflation
c. the dollar will fall even further.
d. the dollar will increase in value in the currency markets.
8. If Japan is a capital abundant country and exports AND imports a large number of automobiles every
year, her trade flow in automobiles is most likely based on
a. product differentiation
b. the Heckscher-Ohlin theorem.
c. the theory of comparative advantage.
d. the theory of absolute advantage.
e. all of the above.
9.
a.
b.
c.
d.
The supply of foreign exchange will decrease if which of the following occurs?
Demand for U.S. goods decreases overseas.
The U.S. demand for imported goods decreases.
The U.S. demand for imported goods increases.
Demand for U.S. goods increases overseas.
10. Suppose there is a decline in the U.S. demand for British goods. You would predict that
a. the demand curve for dollar will shift to the right and the pound will appreciate.
b. the supply curve for the pound will shift to the left and the dollar will appreciate.
c. the demand curve for the pound will shift to the right and the pound will appreciate.
d. the demand curve for the pound will shift to the left and the pound will depreciate.
11. Imports
a. supply us with foreign exchange, and thus they are registered as a credit item in the balance of
payments current account.
b. supply us with foreign exchange, and thus they are registered as a debit item in the balance of
payments current account.
c. cause foreign exchange to leave the country, and thus they are registered as a debit item in the
balance of payments current account.
d. cause foreign exchange to leave the country, and thus they are registered as a credit item in the
balance of payments current account.