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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.
SRAS
P
2
SRAS´
1
AD
Y
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.
YP
P
SRAS
1
P**
2
AD
´
AD
Y
A decline in consumer confidence would reduce the demand for consumer goods
at any level of prices. This would shrink demand at any price level. If this effect
were dominant the price level would fall.
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.
The lower US interest rates would make HK dollar deposits more attractive to
both HK and US investors. The supply of US dollars in the forex market would
increase and the demand would fall leading to appreciating pressure on the Hong
Kong dollar. To stabilize the exchange rate, the central bank would need to
engage in a foreign currency intervention to mop up the extra supply of HK
dollars. If the central bank buys the foreign currency, they will expand the money
supply by printing more domestic currency to buy the foreign currency. This will
reduce interest rates in HK, having the opposite effect on supply and demand of
forex. The appreciating pressure is shown with the red arrows. The reverse effects
of the foreign currency intervention are drawn with green arrows.
S
Supply
Supply′
1
Demand
2
Demand′
Q
Money
Supply
i
Money
Demand
1
2
Money
Supply´
Y
b. Show the impact of this event on Hong Kong’s business cycle using the ASAD model.
LRAS
P
SRAS
3
2
SRAS´
1
AD´
AD
Y
YP
Lower interest rates in Hong Kong would reduce the cost of financing short-term
consumer and investment items increasing demand. This would lead to a shortterm boom in the economy and ultimately higher prices.
c. Which sectors of the Hong Kong economy are likely to benefit from these
actions?
Retail firms that sell these consumer items may especially benefit from lower
interest rates along with borrowers. Savers may not benefit especially since
inflation will rise in the future.
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. Consumers save more and spend
less. This will raise the real interest rate and reduce investment.
r
S
2a
S´
1
I
Loanable Funds
b. Now, consider the impact of this on the Japanese output gap and price level
using the AS-AD model.
As Japanese consumers spend more, the quantity of goods demanded will rise.
LRAS
P
SRAS
LT
2
1
SRAS´
AD´
AD
Y
YP
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.
r
2b
S´
S
I´
1
I
Loanable Funds
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.
As firms invest more during the boom, the demand for loanable funds increases.
With rising demand and declining supply of loanable funds the real interest rate
will rise, but the impact on investment will be ambiguous. On the one hand
investment at any real interest rate will rise, but the rising real interest rate will
have a negative impact on investment as well.
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
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%
Inflation
Gap
1.02%
1.22%
-0.30%
-0.74%
-1.31%
-2.12%
-1.87%
-0.25%
-1.33%
-2.33%
-2.71%
Taylor
Rule
7.68%
8.37%
5.30%
3.65%
2.10%
0.71%
2.77%
5.28%
1.76%
-0.23%
-0.86%
a.
Calculate the inflation gap 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?
Average Inflation Gap
90-95
-0.37%
96-00
-1.70%
b.
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. Does the Bank of Japan adjust the target interest rate to domestic inflation and
As inflation has fallen below the target, the central bank has also cut the interest rate.
c.
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?
Actual
Implied
Average Interest Target
2.09%
3.30%
During the onset of the recession, the Japanese interest rate target seemed to be
on average lower than that implied by the target. In 1992 and 1993, the interest
rate was slightly above the implied rate.
d.
What difficulties did the Bank of Japan have in implementing the Taylor rule in
1999 and 2000?
By 2000, the interest rate had reached a zero lower bound. Even if the Taylor rule
suggests cutting rates, the BoJ cannot.