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Homework 5 Economics 503 Foundations of Economic Analysis Assigned: Week 5 Due: Week 6 1. In 2005, a hurricane hit New Orleans, Louisiana, an important transportation and oil refining center in the USA, one of Hong Kong’s key for the petrochemical industry in that country. Consider the impact of the recent hurricanes that devastated that city as a temporary supply shock for the USA. a. Discuss briefly, using one graph, the outcomes that we would have been likely to see in terms of goods markets in the USA as a result of this negative business cycle shock. b. Analysts are also worried that the natural disaster might have had a negative impact on consumer confidence. Discuss briefly, using one graph, the differences in outcomes that we would observe if this demand side effect were stronger from the outcomes that we would observe if the supply side effects were dominant. 2. The U.S. Federal Reserve cuts its interest rate target. a. Draw graphs of Hong Kong’s money market and Hong Kong’s foreign exchange market to show the impact of this event keeping in mind that it will be the policy of Hong Kong’s central bank to keep the exchange rate fixed. b. Show the impact of this event on Hong Kong’s business cycle using the ASAD model. c. Which sectors of the Hong Kong economy are likely to benefit from these actions? 3. In Japan, consumers become suddenly less thrifty so that savings drops and consumption increases. a. Show the direct impact of this on the Japanese real interest rate and equilibrium investment using the loanable funds market model. Assume for simplicity that Japan is a closed economy. b. Now, consider the impact of this on the Japanese output gap and price level using the AS-AD model. c. Assume that the financial accelerator effect is very strong in Japan. Draw the impact of the financial accelerator on the Japanese real interest rate and the loanable funds market during the business cycle. d. Could we say that real interest rates are likely to rise in a business cycle boom driven by consumer spending? Can we say whether corporate investment is likely to fall or rise? Explain. 4. Does the BOJ have a Taylor Rule? The following table shows numbers for Japan’s inflation rate, output gap, and the uncollateralized call money interest rate for the years 1990 to 2000. 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 i. ii. iii. iv. Output Actual Target Gap Inflation Interest Rate 3.30% 3.02% 7.56% 4.09% 3.22% 7.48% 2.50% 1.70% 4.82% 0.51% 1.26% 3.18% -0.87% 0.69% 2.41% -1.20% -0.12% 1.15% 2.14% 0.13% 0.48% 2.32% 1.75% 0.52% -1.48% 0.67% 0.44% -2.46% -0.33% 0.06% -2.57% -0.71% 0.12% Calculate the inflation gap (i.e. the difference between inflation and target inflation) in each period if Japan had used a target inflation rate of 2% in each year. What is the average inflation gap during the period 1990-1995 (inclusive) and for 1996-2000? Calculate the interest target, iTGT, for every period if the Bank of Japan had used a Taylor rule with an anchor real interest rate of 2.5% (r* = .025). Compare this with the actual target. Does the Bank of Japan adjust the target interest rate to domestic inflation and output? Some have argued that the BOJ was not aggressive enough in cutting interest rates in the early 1990’s to get the economy out of the slump. What was the average interest rate during the period 1992-1997? What was the average interest rate suggested by a Fed-style Taylor rule. Which was larger? What difficulties did the Bank of Japan have in implementing the Taylor rule in 1999 and 2000?