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Answers to Odd-Numbered Self-Test Questions
Chapter 1
1. Answers will vary. Microeconomics is the study of the allocation of resources and of
price determination in individual markets for goods and services. Macroeconomics is the
study of a nation's aggregate economic activity. Rather than focus on individual markets
for goods and services, macroeconomics focuses on the study of aggregate economic
variables (e.g. total output, the overall price level, aggregate employment).
3. As we shall see later in the text, production is a function of employment, the capital
stock and technology (in addition to any other factors of production). In particular,
differences in nations' populations can cause differences in the levels of production. For
example, a country with a larger population will have, all else fixed, a higher level of
production. In practice, a simple comparison of the level of output for two countries can
provide misleading information about the standard of living of individuals in these two
countries. Economists often measure output on a per capita (i.e., per individual) basis to
adjust the output levels for any differences in the size of populations. Output per capita
provides a better signal about the performance of a nation's economy since we can obtain
information about the amount of output 'available' to each individual in that country.
While output per capita will not necessarily be a perfect measure of the performance of
an economy or of the well being of all individuals (we might, for example, also be
interested in the distribution of the output across individuals), it is a better measure than
the level of total output.
Chapter 2
1. Answers will vary. GDP is the market value of all final goods and services produced
within a nation's borders during a given period. GNP measures the market value of all
final goods and services produced by domestically owned factors of production. GNP,
therefore, includes the earnings of domestic residents who live abroad and excludes the
income of foreign residents who live in, for example, the United States. GDP excludes
the earnings of domestic residents who live abroad and includes the income of foreign
residents who live in, for example, the United States.
3. Answers will vary. Nominal GDP is the value of all final goods and services
produced within a nation's borders during a given period measured in current prices.
Real GDP is the value of all final goods and services produced within a nation's borders
during a given period measured in some particular year's prices (i.e., the base year).
5.
It is important that the individual (i.e., student!) realize the overall balance of
payments records all transactions with the rest of the world. Consequently, for each
transaction between a domestic resident and a foreign resident, there is both a payment
and a receipt. When we combine all transactions in all the accounts included in the
overall balance of payments, the overall balance of payments must be equal to zero.
Chapter 3
1. In this model, output is determined by the equilibrium level of employment given
some aggregate production function. Therefore, output growth will be determined by the
rate of growth in equilibrium employment (which will be affected by, all else fixed,
population growth) and any factors that cause the aggregate production to shift.
Consequently, output growth will also be affected by changes in technology, land (i.e.,
resources), capital, and entrepreneurship.
3. The analysis for question 2 indicates that this increased participation by women in the
labor force will cause an increase in aggregate supply. The increase in aggregate supply
(i.e., the rightward shift in the aggregate supply curve) will cause an increase in
equilibrium GDP and a reduction in the aggregate price level. Why does P fall? At the
initial price level, firms are willing to produce more goods and services than households
are willing to purchase. As a result of this, P falls to restore equilibrium.
5. The reduction in the capital stock causes a reduction in aggregate supply. At the
initial price level, firms are willing to produce fewer goods and services than households
are willing to purchase. Consequently, the aggregate price level will rise.
Chapter 4
1. In this case, the demand for loanable funds would rise and the money supply would
not change. So, we would observe no change in P and an increase in both the nominal
and real interest rates.
3. The real interest rate is determined by the supply of and demand for loanable funds.
The real interest rate will remain constant when saving and investment (plus any budget
deficit/surplus) do not change. The nominal interest rate would fall as a result of any
event that causes in this model a reduction in the aggregate price level. As the aggregate
price level falls, inflation would fall and, therefore, the nominal interest rate would fall.
Could the real interest rate increase as the nominal rate falls? Yes. In fact, this is what
occurred in the early to mid 1980s in the United States. This would require either a
reduction in saving (decrease in the supply of loanable funds) or an increase in
investment (or increase in the budget deficit) to cause an increase in the real interest rate.
We would also have to observe some reduction in expected inflation. It is important to
emphasize, however, that the reduction in expected inflation would have to exceed the
increase in the real interest rate to cause the nominal interest rate to fall. The drop in
expected inflation could be caused by, for example, a reduction in the money supply.
5. There are two simultaneous events here: (1) the increase in the budget deficits; and (2)
the increase in the money supply. The increase in budget deficits will cause an increase
in the demand for loanable funds and an increase in the real interest rate. The increase in
budget deficits has no effect on aggregate demand, real GDP and the price level in the
Classical model. The response of the central bank to purchase the bonds causes an
increase in the money supply, an increase in aggregate demand, an increase in the price
level and, again, no change in real GDP. The nominal interest rate will rise for two
reasons: the increase in the real rate and the increase in the rate of inflation (as the price
level rises to its higher level). With P higher, the domestic currency must depreciate to
maintain purchasing power parity. Therefore, E is higher.
Chapter 5
1. Increases in population growth will most likely cause an increase in labor force
participation and, therefore, an increase in employment. This increase in employment (a
factor of production) will cause an increase in the rate of growth of output (y) and,
therefore, tend to cause an increase in economic growth. At the same time, an increase in
population growth will have a direct negative effect on per-capita GDP. This tends to
offset the first effect. Therefore, the effects of population growth on economic growth
are ambiguous.
3. The more productive is capital, by definition, the higher is the marginal product of
capital. As the marginal product of capital increases, investment will increase. Increases
in investment will cause increases in the capital stock. Greater capital accumulation will
causes increases in economic growth.
5. One of the factors that determines economic growth is the extent to which
individuals can use technological improvements to raise their productivity levels.
Increases in education (i.e., the accumulation of human capital) will allow
individuals to better use improvements in technology and, therefore, increase
economic growth. Furthermore, the relationship between education and capital
formation, new growth theorists argue, can make economic growth selfperpetuating. Increases in capital formation make it more profitable to acquire
information. The acquisition of this knowledge, in turn, may make it more
profitable to invest. Hence, capital formation increases further.
Chapter 6
1. The trough of the business cycle occurs at that level of output that maximizes the
difference between natural GDP and actual GDP. Throughout the entire business cycle
(with the exception of negative supply shocks which would cause a reduction in natural
GDP), natural GDP increases at some positive rate of growth. As the economy enters a
recession, output begins to fall. At some point, the level of output will hit some
minimum level and begin to increase. This minimum level of output is not the trough.
As y begins to increase (as depicted in Figure 5-1), the now positive rate of growth in
actual GDP, while positive, will remain below the rate of growth in natural GDP.
Consequently, the gap between natural GDP and actual GDP will continue to increase.
Once the actual GDP growth exceeds the rate of growth in natural GDP, the gap between
the two measures decreases. This turning point, at which the rates of growth in actual
and natural GDP are equal, is the trough. The same type of analysis applies to the peak.
The peak occurs at that level of output where the difference between actual and natural
GDP is maximized. At some point, the rate of growth in y will fall (but remain positive).
Given that natural GDP increases at some positive rate of growth, the difference between
the two measures of output will decrease despite the fact that the level of actual GDP is
still increasing and will, at some point, reach some maximum before the economy enters
another recession.
3. Suppose your disposable income increases by 100. A certain percentage of this will
be used to purchase domestic goods, while a certain percentage of it will be used to
purchase foreign goods. Whatever remains, by definition, is allocated to saving. Hence,
all of the additional disposable income is allocated in some fixed proportions to c, im and
s. The sum of these proportions must equal one. Since these proportions represent the
MPC, MPIM and MPS, we know that the sum of these marginal propensities must equal
1.
Chapter 7
1. The marginal tax rate represents how much one's taxes increase for a given change in
income. The average tax rate is simply the ratio of the total level of taxes to total income.
3. A change in lump-sum taxes causes an equal change in disposable income and
aggregate expenditures (via consumption) at each level of income. Hence, the aggregate
expenditures schedule shifts when lump-sum taxes change. A cut in the income tax rate
will cause the aggregate expenditures schedule to become steeper. With a lower tax rate,
a given change in total income now has a greater effect on disposable income and,
therefore, on consumption. Hence, a given increase in income now has a greater effect
on aggregate expenditures. The aggregate expenditures schedule is steeper to reflect this.
5. If the Ricardian equivalence proposition holds, we should observe increases in saving
when budget deficits increase. Individuals, realizing that increases in budget deficits
today will cause increases in taxes in the future, will increase saving today. During the
1980's, we observed increases in budget deficits and reductions in saving rates. This
observation tends to refute the predictions of the Ricardian equivalence proposition.
Chapter 8
1. Answers will vary. The LM curve represents the combinations of the nominal interest
rate and level of real income that maintain equilibrium in the money market. An increase
in y will cause an increase in both the transactions and precautionary demand for money.
At the initial interest rate, there will exist an excess demand for money. Equivalently,
there will exist an excess supply of bonds. Bond prices will fall and the interest rate will
increase. The interest rate will continue to increase until equilibrium is restored. Hence,
an increase in output requires an increase in the nominal interest rate to maintain
equilibrium. Therefore, the LM curve is upward sloping.
Changes in y will only cause movements along the LM curve. Given the definition and
construction of the LM curve, the effects of changes in y on the money market are
already incorporated in the shape of the LM curve. The LM curve will shift when the
real supply of money changes or when exogenous changes in money demand occur.
3. If the economy is operating on both the IS and LM curves, we know that both the
goods market and money market are in equilibrium. We also know that there will be no
pressure for firms to change output (since actual investment equals desired investment).
We also know that there will be no pressure for the interest rate to change since the
money market and bond market are in equilibrium. When the economy is operating at a
point of IS-LM equilibrium, there is no pressure for either r or y to change.
Chapter 9
1. An appreciation makes domestic goods relatively more expensive. Therefore, exports
fall and imports rise. This will cause a reduction in demand and a leftward shift in the IS
curve. With an appreciation, net exports will fall causing, all else fixed, a BP deficit. To
maintain BP equilibrium, either y must fall (to cause imports to fall to offset the initial
reduction in net exports) or the domestic interest rate must rise to cause a capital inflow.
Either explanation indicates that an appreciation causes the BP curve to shift to the left
(or up).
3. Regardless of the degree of capital mobility, the economy would return to its original
level of income and interest rate. Suppose the monetary contraction causes a private
payments surplus. This would be represented by an increase in the demand for the
domestic currency. To prevent the appreciation of the domestic currency, the central
bank would have to buy foreign currency and, therefore, increase it foreign exchange
reserves. As it does this AND does not sterilize, the money supply will increase. This
continues to occur until the private payments surplus is eliminated. In short, the LM
shifts left and then returns to its original position.
5. Regardless of the degree of capital mobility, the monetary contraction will initially
cause a private payments surplus. This surplus will cause an appreciation of the domestic
currency. For example, in the United States, the dollar would appreciate. As the dollar
appreciates, both the IS and BP schedules adjust causing the private payments surplus to
disappear.
Chapter 10
1. Aggregate demand in the classical model is a special case of aggregate demand in the
Keynesian model. Specifically, money demand is independent of the interest rate in the
classical model. Using the IS-LM model, any increase in government spending will have
no effect on equilibrium income when the LM curve is vertical. Therefore, changes in g
have no effect on aggregate demand when money demand is independent of the interest
rate. Alternatively, there is complete crowding out in the classical model preventing any
shift in the aggregate demand schedule. In the Keynesian model, money demand is a
function of the interest rate. Consequently, the LM curve is upward sloping and changes
in g do cause changes in equilibrium real income. So, changes in g do cause changes in
aggregate demand in the Keynesian model.
3. parts (a) and (b). The answer to this question can be illustrated using one graph and
two different BP curves. In the low mobility case, a BP deficit will occur that will cause
a depreciation and further stimulate output. In the high mobility case, a BP surplus will
occur causing an appreciation. This appreciation will cause net exports to fall and
partially offset the effects of the increase in g on y and, therefore, on aggregate demand.
5. A reduction in the expected price level will cause labor supply to increase (i.e., shift to
the right). For any given price level, this rightward shift in labor supply will result in an
increase in employment and, therefore, an increase in output. In terms of the aggregate
supply curve, this reduction in the expected price level indicates that the level of output
will be higher at each price level. In short, the aggregate supply schedule shifts to the
right when the expected price level falls. See the graph below. Note: NS' and yS' refer to
the labor supply and aggregate supply schedules which correspond to the lower expected
price level. To save space, I have omitted the graph of the aggregate production function.
W
P
S
N
S
y S'
N S'
A
y
P1
A
B
B
MPxP
1
N
1
N2
N
y
1
y
y
2
7. The views are clearly not affected by the classical model since changes in the money
supply will have no real effects in the classical model (i.e., the Fed cannot affect output in
that model). We should note that in both the Keynesian and monetarist models the Fed
can affect output in the short-run. Therefore, the implicit assumption in these views (i.e.,
that the Fed can affect real economic activity) is consistent with both the Keynesian and
monetarist theories. The views are most likely swayed by the Keynesian theory since the
individual is concerned with the Fed's policy negatively affecting output in the short-run
(and long-run). An individual influenced by the monetarist theory would understand that
Fed actions will have no effect on output in the long-run.
9. In the long run, workers and firms can fully adjust their expectations of inflation.
Therefore, in the long run, expected and actual inflation will be equal. Increases in
inflation (i.e., the rate at which the price level increases) will have no effect on the level
of employment, output, and, therefore, the unemployment in the long run. The long-run
Phillips curve is vertical to illustrate this.
11. As noted in the chapter, the inflation and unemployment experience in the United
States between 1971 and 1991 appears to fit the predictions of the political-businesscycle theory. However, we would tend to see greater changes in output around those
periods in which a new party took control of the White House. More importantly, we
know that the U.S. economy was affected by supply shocks during this period (i.e., the
increases in oil prices in the 1970's and the reduction in oil prices in the mid-1980's that
influenced these fluctuations in inflation and unemployment). We also know that Fed
policy beginning in 1979 contributed to the reduction in inflation. So, while some of the
fluctuations in unemployment and inflation might be consistent with the predictions of
the political-business-cycle theory, there are other events during this period that had a
significant effect on inflation and unemployment dynamics.
Chapter 11
1. An adaptive expectation is based solely on the use of past information to obtain a
forecast of some future variable. A rational expectation uses both past and current
information combined with an understanding of how the economy (or relevant market)
operates to form an expectation of a variable. A rational and adaptive expectation can
still be the same. For example, a simple average of past inflation might yield an expected
inflation rate of 4% for the coming year. Using past and current information about
macroeconomic policy and an understanding of the macroeconomy, it is possible that the
rational forecast of future inflation could also be 4%.
3. Suppose they expect the price level to drop by 4% and it actually drops by 6%.
Output would decline in the new classical model in the short run. In this case, the price
level falls by more than individuals expect. As the price level falls below the lower
expected price level, the demand for labor falls causing a reduction in the nominal wage.
As the nominal wage falls, individuals believe that there is a reduction in the real wage.
They, therefore, reduce the quantity supplied of labor. The drop in employment causes a
reduction in output. In the traditional Keynesian and monetarist models, the expected
price level would not immediately change. In other words, there would be no initial shift
in the labor supply and aggregate supply schedules (to reflect the drop in the expected
price level). In these cases, there would be a greater perceived reduction in the real wage
as the nominal wage falls. The greater reduction in employment would cause a greater
reduction in output.
5. The only way monetary policy can affect output is if the change in the money supply
is unexpected. Therefore, secrecy is needed if monetary policy is to be used to affect
economic activity. However, this secrecy will simultaneously create uncertainty about
the course of monetary policy. For example, if individuals expect the Fed to pursue a
monetary expansion, they will revise upward their expected price level. If, however, the
Fed does not act, output will fall as aggregate supply falls. This uncertainty about the
course of monetary policy (caused by the secrecy of Fed policy) can, therefore, cause
fluctuations in output. Secrecy about Fed policy can thus destabilize the economy.
7. Answers will vary. The covered interest parity condition indicates that the return from
holding U.S. bonds will be equal to the return from holding German bonds. The return
from holding German bonds is based on the individual buying euros in the spot market at
a price S and simultaneously agreeing to sell euros in the forward market at a price of F.
Excluding the possibility of default, the individual is able to "lock in" a fixed rate of
return on the German bonds by using the forward market. The uncovered interest parity
condition again indicates that the return from holding U.S. bonds will be equal to the
return from holding German bonds. The return from holding German bonds is now
determined based on the expected rate of depreciation of the dollar plus any risk
premium. In this case, the individual does not lock in any guaranteed return. The
realized returns on the German bond will depend on the actual future spot rate in, say,
one year (assuming one-year bonds).
Chapter 12
1. Answers will vary. There are three reasons why fixed-wage contracts may be rational.
First, such contracts help reduce labor-market transaction costs. A fixed-wage contract
will reduce the frequency of negotiations and, therefore, reduce the transaction costs
associated with this process. Second, risk averse firms and workers might prefer to fix
the nominal wage for a given period rather than face the possibility of fluctuating wages
which might make them worse off. And finally, the existence of asymmetric information
might make fixed-wage contracts rational. For example, firms might wish to fix the
nominal wage at some level in order to reduce shirking of workers.
3. In the absence of contracts (e.g. the classical model), this increase in labor supply
would increase employment and increase output. With contracts in place, however, the
level of employment will not change. Since employment does not change, output will not
change. The only result we will observe in the short run is an increase in the
unemployment rate.
5. Yes. The more significant the contract staggering and overlap, the more persistent
the effects of changes in aggregate demand on the economy. This increase in the
persistence of business cycles is inconsistent with the predictions of the new classical
theory. In the new classical theory, the business cycle will persist only as long as
expectations of prices (and policies) do not change. Once expectations adjust, the
economy will return to the full-information level.
7. No. An unanticipated increase in the nominal money stock will increase aggregate
demand and the price level. Even though the price level is now above expected, the
nominal wage will adjust proportionately to this unexpected increase in the price level.
While labor demand will increase as the price level rises, the nominal wage will increase
proportionately leaving the real wage constant. Since the real wage does not change, the
level of employment and output does not change. In short, the short-run aggregate supply
schedule becomes vertical. This Keynesian model would be observationally equivalent
to the classical model.
9. See the graph below:
W
s
N (Pe)
P
s
y (Wc)
c
W
P1
P
2
MPxPe
d
y2
MPxP2
N
2
N
1
y
2
y
1
y
d
1
y
Note: The expected price level equals P1. The unexpected drop in aggregate demand
causes a reduction in the price level. As the price level falls, the real wage increases
(since the nominal wage is fixed at Wc as a result of the contract). Here we have a
reduction in output associated with an increase in the real wage. The evidence on the
relationship between real wages and the business cycle indicate, however, that the real
wage falls when output falls.
Chapter 13
1. See the graph below:
P
yS
1
C
P
2
P1
y
A
S*
1
B
y
d
y
1
y
1
y y
2 2*
d
2
y
Point A represents the initial equilibrium. I have shown two aggregate supply schedules
in the above graph. yS1 represents some "normal" aggregate supply schedule while yS*1
represents an aggregate supply schedule for which prices are completely sticky. Clearly,
the effects of the increase in aggregate demand depend on the flexibility of prices. If, for
example, prices (and wages) were completely flexible, the increase in aggregate demand
would have no effect on economic activity. In the above graph, as prices become more
"sticky," the output effects of the increase in aggregate demand increase; compare the
levels of output associated with points B and C. In short, the potential effectiveness of
monetary and fiscal policy will depend crucially on the stickiness of prices.
3. Increases in the real wage will cause an increase in worker productivity. As worker
productivity increases, the aggregate production function will pivot (and shift) upwards.
5. Answers will vary. The inability or failure of workers and firms to coordinate their
actions in the presence of macroeconomic externalities may cause the level of output to
deviate (generally fall below) the long-run (full-information with price flexibility) level.
7. The new classical model in Chapter 9 is an equilibrium model; recall that wages
increase in response to an increase in labor demand. In the modern Keynesian model, the
labor market is not in equilibrium when labor demand increases. The real-business-cycle
model is also an equilibrium model and, therefore, is more closely related to the new
classical model. While this is a bit redundant, the real-business-cycle model also
assumes wage and price flexibility, an assumption that again is more closely related to
the new classical model.
9. Answers will vary. There are benefits to using both approaches. There are also risks
to relying solely on just one of the approaches. Drawing general conclusions from
reference to observed data can result in theories that do not best represent the behavior of
the macroeconomy. At the same time, making policy recommendations based on a
theoretical model derived from deduction also has its drawbacks. For example, the
Keynesian model assumes that real wages are counter-cyclical. However, many studies
indicate that actual real wages are pro-cyclical. Such an observation raises questions
about the appropriateness of policy recommendations based on a model for which one of
its assumptions appears to be contradicted by an analysis of the data.
Chapter 14
1. The Fed uses open market operations as its primary way of conducting monetary
policy. In contrast to changes in the discount rate and required reserve ratio, this is the
easiest way for the Fed to affect directly the quantity of reserves in the economy. While
changes in the other two policy instruments would affect the quantity of reserves, the Fed
can more quickly implement open market operations through the trading desk in New
York.
3. The criteria are: frequently observable, consistency with ultimate goals, definable and
measurable, and controllable. Again, answers will vary. In many ways, no one of
characteristics is MOST important since the success of policy makers depends on
selecting an intermediate target that possesses at least several of them.
5. The use of a nominal GDP rule insulates the economy from any shock to aggregate
demand (this would include both shocks to money demand and to autonomous
expenditures). In fact, output would not change when such a rule is in place. The
nominal GDP rule would also limit the inflationary effects of a supply shock. With either
a monetary aggregate or interest rate target, the price level will respond more when
shocks to aggregate supply occur. The disadvantage with a nominal GDP rule is that
information about nominal GDP is not as readily available as is information about either
monetary aggregates or interest rates.
7. The national debt is a stock; it can be measured at a point in time. The budget deficit
is a flow and represents the addition to the national debt for a given period.
9. Answers will vary. The assignment problem deals with the decision to use monetary
and fiscal policy to achieve internal balance and external balance. Depending on the
initial situation (and on the level of capital mobility), the required monetary policy action
to achieve internal balance could worsen the external balance situation. Conversely, the
required fiscal policy action to achieve external balance could worsen the internal balance
situation. Obviously, these explanations can be reversed. In many ways, this discussion
is an application of the policy mix issue. Solving the problem is important since
achieving internal and external balance is important. To achieve both simultaneously
will require the correct combination (and, therefore, assignment) of monetary and fiscal
policy.
Chapter 15
1. The recognition lag is the amount of time between when the policy action is needed
and when policy makers recognize that a policy action is needed. The response lag is the
amount of time between when policy makers recognize an action is needed and when the
policy action can be implemented. And finally, the transmission lag is the amount of
time it takes for the policy action to affect the overall economy. The least problematic
for monetary policy is the response lag. Once Fed officials recognize a policy is needed,
it could be implemented very quickly; members of the FOMC could be in contact that
day and decide on an action that day. Answers will vary for the most problematic. In
many ways, the recognition lag and transmission lag are both problematic for monetary
policy. The Fed does not always know with certainty the direction of the economy.
Furthermore, the lagged effects of changes in monetary policy can change over time.
3. Central banks and governments may be uniquely qualified because they may possess
information advantages. For example, Fed officials might have a better understanding of
how the economy operates or, more obviously, what effect future Fed actions will have
on financial markets. This information advantage would, proponents argue, enable policy
makers to conduct successful discretionary policy. Public choice theory casts doubt on
this by arguing that policy makers act to maximize their own self-interest. Rather than
care about the macroeconomic goals typically associated with macro policy makers, these
individuals would act to benefit either themselves or, for example, the banking industry.
In this case, discretionary policy would be used not to achieve, for example, price
stability, but to achieve some other goal.
5. First, wage indexation is not costless. Second, complete wage indexation would be
optimal only if aggregate demand was variable. If aggregate supply is variable, complete
wage indexation would not be optimal. Third, complete wage indexation would require
the coordinated actions of many different workers and firms.
7. Political independence represents the freedom the central bank has to make its
decisions. Economic independence refers to the ability of the central bank to control its
own budget and, therefore, to have the budgetary freedom to conduct policies. Yes, both
types of independence would generally be needed. One can easily construct cases where,
without one of these types of independence, the central bank would not be as successful
in reducing inflation.
Chapter 16
1. Yes. This is a rather standard example of the benefits of a flexible exchange rate. If
the exchange rate is allowed to fluctuate, the exchange rate will serve as the "shock
absorber." Specifically, the drop in demand for the economy's goods will eventually
cause a depreciation of the domestic currency. As this occurs, the economy's goods
become more competitive and demand increases. This would partially (or in the case of
perfect capital mobility, completely) offset the drop in demand. With fixed exchange
rates, this adjustment would not occur.
3. If we can assume that the central bank is independent and credible, the answer would
be: flexible exchange rate regime. Monetary policy can more quickly respond to changes
in economic conditions. Because of this, we would want an exchange rate regime in
which monetary policy (i.e., changes in the money supply, given the exchange rate
regime) could affect output. This can only happen with a flexible exchange rate regime.
In theory, fiscal policy would be successful in a fixed exchange rate regime; however, the
relatively longer lags associated with fiscal policy make fiscal policy and, therefore, a
fixed exchange rate regime a less attractive option.
5. The fiscal authority loses power. Once again, as financial markets become more
integrated, we would also expect that capital will become more mobile. As the degree of
capital mobility increases, the output effects of changes in government spending
decrease. In particular, there is a larger appreciation of the domestic currency and,
therefore, an increase in the size of international crowding out. In the extreme, fiscal
policy is completely ineffective with perfect capital mobility.
7. The tables provided by students here will vary considerably. Their answers to the last
question should reflect some of the issues discussed in the chapter.
9. This is an interesting question. Answers will likely vary. In many ways, how one
answers the question depends on what one assumes "private market interest rates" to be.
Presumably, these multinationals exist to assist the development of emerging economies.
If they price the credit according to risk, in theory, these emerging countries could just as
easily borrow in credit markets. So, one could argue that these loans should be
subsidized. However, if one argues this, there should be strict conditions both before and
after the loan is made. Otherwise, such a lending policy could be problematic.