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EXAM II
ECON3900
SPRING2006 NAME:_____________________________
1)
Small Open Economy
Y = 50000
C = 10000 + 0.75 * ( Y – T )
I = 10000 – 500 * r
G=T=0
a)
For this part, assume that this is a CLOSED economy and compute the
equilibrium interest rate.
15%
b)
Now, return to the assumption that this is an open economy. What should be
the world interest rate (define the range) in order for this country to
experience trade surplus?
World interest rate has to be greater than 15%
c)
What if the world interest rate is 5%? Will this economy experience trade
deficit or surplus, and how much?
Trade deficit of 5000
d)
Now, assume that the world interest is still 5%, but the government of this
country selects to run expansionary fiscal policy and increase G = 10000,
while T is increased to 5000 only. What is the new level of international trade
balance for this country?
National saving substantially declined : public by 5000 and private by 1250, the net
exports increased by 6250 to 11250.
2)
Using supply/demand framework illustrate and explain the effects of each of
the following on the USD (please employ the ceteris paribus assumption in
each case).
a) A decrease in the Federal Funds Rate by the FED
The demand for the USD in the ForEx market decreases as the return on US assets such
as bonds, CDs decreases. Thus, the USD should depreciate in value
b) An increase in the US inflation rate
The US prices are rising at a faster rate, this should hurt the US competitiveness
internationally and thus worsen the US trade balance. The demand for US goods overseas
will decline (hence the demand for the USD will decline as well), in addition, the demand
for foreign goods in the US will increase (hence the supply of the USD will increase
also). The dollar should depreciate.
c) A reduction of the interest rates in the Euro zone and other major economies
This should make the US investments appear more attractive as the overseas investments
reduce the return. Thus should increase the demand for the USD and hence cause an
appreciation of the US currency.
3)
Assume that the average price of internationally traded goods for the Russian
economy is 3000 roubles, and for the US economy, the same average price is 100
USD.
a. In order for the real exchange rate value between the dollar and the rouble to be
one (i.e. the purchasing price parity to hold), what should be the nominal
exchange rate between these currencies?
The law of one price suggests that the USD should purchase 30 Roubles.
b. If the nominal exchange rate is R 35 = USD 1, which country should experience
trade deficit and why?
The dollar is overvalued and hence the US should experience a trade deficit with Russia
4)
Short answers
a)
Explain the relationship between inflation and
unemployment. Please be sure to explain the concept of
overheating economy in your answer.
Inflation can be generated by the domestic pressure coming from the labor market. If the
labor market becomes too tight, the firms begin to compete for workers and when such
competition pushes the wage growth rate higher inflation may become a threat. Inflation
will accelerate when the rate of growth in wages starts to exceed the growth in
productivity of labor. The reverse will also hold, if the labor market is soft, there should
be limited pressure on the prices, i.e. the unemployed do not bid up the housing, TV, …
prices. The labor market is considered to be tight when the unemployment rate drops
below the natural unemployment rate, and is said to be soft when the unemployment rate
exceeds the natural unemployment rate. Hence, if the unemployment rate is lower than
the natural unemployment rate inflation is on the rise, and if the unemployment rate is
higher than the natural unemployment rate, inflation is on the decline.
5)
True/False (explain)
a)
The natural rate of inflation is achieved when the economy
begins its expansionary part of the business cycle
FALSE. Sufficient to say that there is no such thing as the natural rate of inflation
b)
Unemployment rate is countercyclical to the fluctuations in
the level of real economic activity (real GDP)
TRUE. The demand for labor typically is directly related to the output of goods and
services
6)
Below is a list of commonly used leading economic indicators.
1. Business inventories
2. Average Work hours in manufacturing
3. Average weekly claims for unemployment insurance
4. Construction employment
5. Residential permits
6. Stock index (index futures)
7. Growth in wage rate
8. Productivity growth rate
a) From the list above select the indicators that are designed to predict changes in
inflation and state what should be observed in these indicators in order to predict a
rise in inflation
Indicators 7 and 8. If the growth in the wage rate starts to increase the growth in
productivity, inflation is likely to accelerate.
b) What should be observed in the indicators 1, 2, 4 from the list above in order for
us to be concerned about a possible recession
1. BI should be on the rise
2. AWH in manufacturing should be on the decline
4. Construction employment should be on the decline
Bonus (2 points) Why is the Stock Index on the list in problem 6?
The stock price takes into account expectations of near term future profitability.