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Econ 201 Intermediate Macroeconomics
Assignment 4
(Chapter 18,19, 20)
1. Label each of the following statement true, false, or uncertain. Explain briefly.
a) If the dollar is expected to depreciate against the yen, UIRP implies that the US
nominal interest rate will be greater than the Japanese nominal interest rate.
TRUE. By UIRP, it = i*t‐ (Eet+1‐ Et)/Et , if the dollar is expected to depreciate, then (Eet+1‐ Et)/Et<0. So, i*<I, the nominal interest rate is larger than the Japanese nominal interest rate.
b) The only way a country can eliminate its trade deficit is through a real depreciation.
FALSE. For net export = NX(Y, Y*,ε), trade deficit can be eliminated through decrease Y, increase Y* or real depreciation. c) Other things equal, the interest parity condition implies that domestic currency will
depreciate in response to an increase in expected exchange rate.
FALSE. By UIRP, it = i*t‐ (Eet+1‐ Et)/Et , when i and i* unchanged, Ee increases →E increases. Domestic currency will appreciate against foreign currency. d) Countries with current account deficit must receive capital inflows.
TRUE. Current account deficit must be balanced by the capital account surplus, which implies a capital inflow, assuming no statistical discrepancy. e) The national income identity implies that budget deficits cause trade deficit.
FALSE. The equation of national income identity cannot tell whether an increase in budget deficit cause trade deficit. f) If the Japanese nominal interest rate is equal to 0, foreigners will not hold Japanese
bonds.
FALSE. According to the UIRP (1+it) = (1+i*t)Et/Eet+1, the left hand side represents the return in terms of domestic currency from holding domestic bonds and the right hand side represents the expected return in terms of domestic currency from holding foreign bonds. That is, the return from holding Japanese bond depends not only on the nominal interest rate of the bond, but also the expected changes of exchange rate. When i*t = 0, the right hand side would just become Et/Eet+1 . If the expected depreciation rate of domestic currency is higher (or the same as it, then foreigner may still want to hold Japanese bond even if its nominal interest rate is zero.
2. Question 2 of Chapter 18 in the textbook.
This is done by single entry method. Domestic Country Balance of Payments ($) Current Account Exports 30 Imports 125 Trade Balance ‐95 (=30‐125) Investment Income Received Investment Income Paid 20 Net Investment Income ‐20 Net Transfers Received ‐30 Current Account Balance ‐145 (=‐95‐20‐30) Capital Account Increase in Foreign Holdings of Domestic Assets 75+20 Increase in Domestic Holdings of Foreign Assets ‐60 Net Increase in Foreign Holdings 155 (=95+60) Statistical Discrepancy 10 (=‐145+155) 3. Question 3 of Chapter 18 in the textbook.
a. The nominal return on the U.S. bond is 10,000/(9615.38)–1=4%. The nominal return on the German bond is 6%. b. Uncovered interest parity implies that the expected exchange rate is given by E(1+i*)/(1+i)=0.75(1.06)/(1.04)=0.76 Euro/$. c. If you expect the dollar to depreciate, purchase the German bond, since it pays a higher interest rate and you expect a capital gain on the currency. d. The dollar depreciates by 4%, so the total return on the German bond (in $) is 6% + 4% =10%. Investing in the U.S. bond would have produced a 4% return. e. The uncovered interest parity condition is about equality of expected returns, not equality of actual returns. 4. Question 6 of Chapter 19 in the textbook.
a. The ZZ and NX lines shift up. Domestic output and domestic net exports increase. b. Domestic investment will increase because output increases. Assuming taxes are fixed, there is no effect on the deficit. c. NX=S‐I+T‐G. Since the budget deficit is unchanged, and I and NX increase, S must increase. d. Except for G and (for our purposes) T, the other variables in equation (19.5) are endogenous. An exogenous shock such as an increase in foreign output can affect all of the endogenous variables simultaneously. 5. Question 7 of Chapter 19 in the textbook.
a. Y = C + I + G + X – IM Y=c0+c1(Y‐T)+d0+d1Y+G+x1Y*‐m1Y Y=[1/(1‐c1‐d1+m1)][c0+c1T+d0+G+x1Y*] b. Output increases by the multiplier, which equals 1/(1‐c1‐d1+m1). The condition 0< m1< c1+d1<1 ensures that the multiplier is defined, positive, and less than one. As compared to the original multiplier, 1/(1+c1), there are two additional parameters: d1, which captures the effect of an additional unit of income on investment, and m1, which captures the effect of an additional unit of income on imports. The investment effect tends to increase the multiplier; the import effect tends to reduce the multiplier. c. When government purchases increase by one unit, net exports fall by m1ΔY= m1/(1‐c1‐d1+m1). Note that the change in output is simply the multiplier. d. The larger economy will likely have the smaller value of m1. Larger economies tend to produce a wider variety of goods, and therefore to spend more of additional unit of income on domestic goods than smaller economies do. e. ΔY ΔNX small economy (m1=0.5) 1.1 0.6 large economy (m1=0.1) 2 0.2 f. Fiscal policy has a larger effect on output in the large economy, but a larger effect on net exports in the small economy. 6. Question 4 of Chapter 20 in the textbook.
a. The IS curve shifts right, because net exports tend to increase. Domestic output increases. b. The IS curve shifts right, because the increase in i* tends to create a depreciation of the domestic currency and therefore an increase in net exports. Domestic output increases. The interest parity line also shifts up. c. A foreign fiscal expansion is likely to increase Y* and to increase i*. A foreign monetary expansion is likely to increase Y* and to reduce i*. d. A foreign fiscal expansion is likely to increase home output. A foreign monetary expansion has an ambiguous effect on home output. The increase in Y* tends to increase home output, but the fall in i* tends to reduce home output. 7. Question 7 of Chapter 20 in the textbook.
a. Et=Eet+1(1+it+x)/(1+i*t+1) b. The IS curve slopes down as before, but with the result in part (a) substituted for the nominal exchange rate in the NX function. c. The IS curve shifts right, because the fall in the expected exchange rate creates a depreciation (which leads to an increase in net exports) at the original interest rate. The interest parity line shifts left. Output increases, net exports increase, and the currency depreciates. d. An increase in x tends to increase the value of the domestic currency and therefore to shift the IS curve to the left. According the assumption of the problem, the IS curve returns to its original position. As a result, the combined effect of the increase in the expected exchange rate and the increase in x is no change in output. Since there is no change in output, there is no change in net exports or the exchange rate. The increase in x shifts the interest parity line to the right, back to its original position. e. Yes and yes.