Download Exam 3 with answers

Econ 457, Spring 2017
Exam III, April 18, 2017
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Questions 1 – 18 are each worth 4 points.
1. If the United States cuts its government budget deficit, what impact would there be on
the IS curve?
A) It would shift right due to higher levels of total spending.
B) It would shift left due to lower levels of total spending.
C) It would shift left because of lower levels of total spending, and it would shift right
if U.S. interest rates decline due to lower borrowing.
D) It would shift left because of higher nominal and real interest rates due to increased
borrowing.
2. When exchange rates are fixed, a temporary expansion in the money supply will:
A) Will have to be accompanied by an decrease in government spending to keep a
constant output
B) Have to be reversed by an equal monetary contraction.
C) lower output.
D) increase the exchange rate.
3. In the wake of the world financial crisis in 2008, the Polish economy withstood the
economic impact by:
A) decreasing the money supply and increasing government spending.
B) increasing the taxes.
C) Increasing government spending as well as the money supply.
D) appreciating its currency.
4. Investment will occur in an open economy more often than in a closed economy
because:
A) investment decisions have fewer constraints because investors and borrowers
will compare the marginal product of capital in any nation with the world real
interest rate.
B) without information, investors often make poor investment decisions.
C) governments like to subsidize overseas investment for domestic firms.
D) international financial organizations prefer to lend for international investments
rather than domestic ones.
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5. If the productivity of capital in low-income nations is substantially lower than
productivity in high-income nations, then:
A) output per worker will never catch up to the rich nations, even with access to
capital markets.
B) productivity of capital can be improved by better training of workers and more
foreign investment.
C) output per worker will grow more slowly, but at some point there will be
convergence.
D) the low-income nations will lose their ability to borrow in international markets.
6. Two nations each own 50% of the capital of the other nation (diversification). What is
the situation when labor comprises over 50% of available resources?
A) In order to achieve perfect diversification, labor must move from one nation to the
other.
B) No gain will occur from the diversification.
C) The risk from economic shock will be eliminated by the diversification of assets.
D) Some risk from economic shocks can be eliminated, but not all.
7. When the real exchange rate decreases in the United States, then there is a(n) ______ in
U.S. demand for U.S. goods and a(n) _________ in U.S. demand for Mexican goods.
A) decrease; increase
B) increase; decrease
C) increase; increase
D) decrease; decrease
8. The larger the percentage of U.S. imports already priced in dollars, the less likely
depreciation in the U.S. dollar will be to:
A) decrease prices of imports.
B) increase prices of imports.
C) limit trade imbalances.
D) increase trade with third-party nations.
9. The J-curve effect means that import prices are higher, thus revenues paid out increase
while export prices are lower and incoming revenues decrease. Therefore, after a
currency depreciation:
A) the trade balance will improve, then decline, then improve, and then decline,
appearing to be a series of J shapes.
B) the trade balance will increase, then decrease, then jump higher, which economists
call the J-curve effect.
C) the nation will cut back on imports immediately causing the trade balance to
improve, which gives the curve an inverted J shape.
D) the trade balance decreases and then increases over time giving the curve a J
shape.
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10. At some rate of interest, i, domestic demand is equal to output, and at some exchange
rate, the domestic return is equivalent to the foreign return. This must be one point on:
A) the IS curve.
B) the aggregate expenditure line.
C) the supply curve.
D) the LM curve.
11. If the United States export prices are all invoiced in dollars and 90% of its imports are
also invoiced in dollars, what will be the impact on the Real Exchange Rate of a 10%
depreciation of dollar against all other currencies
A) It would depreciate by 10%
B) It will appreciate by 1%
C) It will depreciate by 90%
D) It will depreciate by 1%
12. A set of combinations of nominal interest rates and GDP, for which the demand for
money is equal to the supply of money, is:
A) the IS curve.
B) the aggregate expenditure line.
C) the supply curve.
D) the LM curve.
13. The % change in real effective exchange rate
A) Equals % change in the nominal exchange rate since the prices are assumed to be
fixed
B) Equals trade-weighted sum of all bilateral real exchange rate % changes
C) Equals the % change in import and export price ratios
D) None of the above
14. The “Home bias” in equities
A) Relates to the observation that countries hold much larger shares of their home
equities in their asset portfolios than the diversification would demand
B) Relates to the observation that countries hold much smaller shares of foreign
equities in their asset portfolios than the diversification would demand
C) Has been diminishing over past two decades
D) All of the above
15. Consider the IS-LM-FX model of output and exchange rates. Under a monetary expansion in
a flexible exchange rate regime, a nation’s trade balance
A)
B)
C)
D)
Does not change
improves
deteriorates
is uncertain
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16. Consider the IS-LM-FX model of an economy. With an increase in government spending, the
trade balance
A) improves under flexible exchange rates, but worsens under fixed exchange rates
B) worsens under both flexible and fixed exchange rates
C) improves under both flexible and fixed exchange rates
D) worsens under flexible exchange rates, but improves under fixed exchange rates
17. The Wall Street Journal article “For Chinese companies if you can’t move money overseas,
raise it overseas” highlights that
A) Chinese firms are raising debt in dollars in foreign bond markets because of Chinese
capital controls
B) In the first quarter of 2017, the dollar funds raised by Chinese firms exceeds $50
billion
C) Some bankers say much of the demand for Chinese dollar bonds is coming from
Chinese investors who have stowed money overseas
D ) All of the above
E) only A and C above
18. The Wall street journal article “China tries to battle the trilemma” highlights that
A) China is trying to manage all three desirable policy goals: fixed exchange rates,
monetary policy independence, and free capital mobility
B) China is imposing complete capital controls to maintain an undervalued exchange
rate and also continue to have its monetary policy independence
C) China is struggling to not let yuan depreciate by resorting to monetary and credit
tightening, which is hurting its domestic banking sector
D) Both B and C above
19.
Suppose that the dollar real exchange rate falls by 10% against the euro, 20% against the
pound, and 25% against the yen. If the United States trades equally with each country,
what is the percentage decline in the real effective exchange rate? [4 points]
Ans: (0.1+0.2+0.25)/3 = 0.55/3 = 18.3%
20. Suppose every quarter US exports 10 million units of widgets at a unit price of $100, and
imports 10 million of another kind from Europe at a unit price of 100 euros.
a. If the exchange rate is 1.3$/euro, what is the US trade balance? (2)
b. Suppose dollar depreciates to 1.4$/euro but there is no change in export/import quantities
and the prices in both countries remain the same. What will be the trade balance for the
next quarter? (2)
c. Now suppose in one year exports increase to 12 million and imports decrease to 8
million. The exchange rate remains at 1.4$/euro, and the prices in both countries remain
the same. What will be the quarterly trade balance after one year? (2)
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See the solution on the class website – this is the example discussed in class – April 4/6.
21. Consider two symmetric (equal-sized) economies, Home and Foreign, in which households
earn income from their capital holdings (shares in the firms), that is capital share of income is
100%. There are two states of the world G and B. In state G, Home’s output is 110 whereas
Foreign’s output is 90. In state B, Home gets 90 while Foreign has 110. Both states, G and B, are
equally likely, i.e., their probabilities are 50% every period. How can the residents of both
countries make sure that their incomes are completely insured, i.e., it remains constant
irrespective of the state of the world? Show your work. (6 points)
Having 50% each of the two shares will ensure that in both good and bad states the income
of Home and Foreign households remains 110*0.5+90*0.5 = 100. There is no variation of
income.
22. Using the IS-LM framework, discuss the effects of an increase in government spending by a
country (a) under a flexible exchange rate system, and (b) under a fixed exchange rate system. (8
points)
In the flexible case, the IS shifts to the right raising output as well as equilibrium interest
rates. Under the fixed exchange rate, to keep the interest rate the same, a shift in LM to the
right would be required by increasing money supply, which will bring the interest rate
down to its previous level. However, the output will rise even further.
23. An open economy’s output is expected to be 100 units forever and it can borrow and lend
freely from the rest of the world at an interest rate 10%. Assume that the initial wealth is zero
and there are no unilateral transfers. An investment opportunity for this economy arises whereby
an investment of 45 units in the first period (i.e., t = 0) will increase its output by 10 units forever
thereafter (i.e., from t = 1 onwards). However, in t = 0 the output will remain at 100. Shall the
economy borrow and undertake this investment? If the economy always chooses a smooth
consumption, what will be the consumption level that it will choose? What will be the trade
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balance in period 0? What will be the wealth level at the end of period 0? What is the trade
balance, NFIA, Current account, and wealth level at the end of period 1, 2, 3,…[12 points]
(Answer: The present value of increase in output is 10/0.1 = 100 and the investment is only 45.
There is net positive worth of 55 in this investment. Undertake it. Consumption is calculated
using
(1 + 1/0.1) C = PV(Q) – I = 100 + 110/0.1 – 45 = 1155.
Thus 11 C = 1155, C = 105.
TB0 = 100 – 105 – 45 = - 50.
W0 = 0 – 50 = -50.
From period 1 onwards, TB = 5; NFIA = -5, CA = 0, and wealth W1 = -50. This repeats forever.
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