Download Homework #3 - UCSB Economics

Economics 181
Homework #3
1.
Suppose that due to the widespread introduction of debit cards in Germany, there
is a permanent fall in money demand. Use a graph of the money and foreign exchange
markets and the AA-DD graphs to show the short run and long-run effects on the German
economy. Discuss results, particularly the impact on the interest rate, nominal exchange
rate, and output.
2.
Suppose that Japanese firms become more optimistic about the prospects for
coming out of their recession in the near future, and they decide to increase investment
expenditure today in new factories and office space.
a. Use the AA-DD curves to discuss the short-run effects of this temporary rise in
investment on Japanese output, interest rate, real exchange rate, and current account.
(Assume that in this case investment is not a function of the interest rate.)
b. Suppose now that investment is responsive to the interest rate, so that Japanese firms
will cancel their new investment plans if the interest rate rises. How will this affect
the story you told in part a?
3.
In order to keep the dollar from devaluating against the yen, the U.S.’s central
banks could intervene by selling yen and buying dollars. However, the pool of currencies
in the marketplace is much larger than most government’s holdings.
On one side, it seems unlikely that market intervention from some of the world’s
most economically influential countries would even have much impact on the currency
markets, due to the vastly large amount of currency that is traded every day. On the other
hand, just the stated intention of a large country’s central banks to intervene in the
currency markets could disrupt the market entirely due to its psychological effects.
a. Do you agree that since the amount of currency traded every day is so immense, that
it is impossible for even some of the largest countries in the world to influence their
country’s exchange rates?
b. Describe how just a country’s stated intention to intervene could have a psychological
effect on the exchange market.
4. Suppose that Malaysia decides to fix its currency, the ringgit, to the Japanese yen at a
rate of 22 yen per ringgit. Later Malaysia finds itself facing a balance of payments (more
precisely, Official Settlements) deficit of 5 billion yen. Discuss the effects of this deficit
on Malaysia’s money supply and the level of foreign assets held by its central bank when
a. Any foreign exchange intervention is sterilized.
b. Any foreign exchange intervention is unsterilized.
c. Under this situation, would the Malaysian currency have been stronger or weaker if
the Malaysian central bank had not intervened in the market for foreign exchange?
5. Consider the case of France following World War II. It is beginning a temporary
period of expansionary government spending as it rebuilds its damaged infrastructure.
And it is considering whether to join the Bretton Woods system of fixed exchange rates.
a. Suppose first that France undertakes its temporary expansionary fiscal policy while
maintaining a flexible exchange rate. State the short-run effects of the fiscal policy on
France’s output, exchange rate, and current account, using the AA-DD-XX graph to
show this.
b. Suppose instead that France fixes its exchange rate and then undertakes the
temporary expansionary fiscal policy. State the short-run effects on France’s output,
exchange rate, and current account, using the AA-DD-XX graph to show this.
Explain each curve shift. Compare the result to your answer in part (a).