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Practice Final Exam
Economics 215
Intermediate Macroeconomics
Assigned: Thursday, May 12, 2005
Multiple Choice (4 points each)
1. A small economy in Africa, Ghana, is one of the world’s major growers of cocoa
beans. When temporary bad weather in Thailand destroys a major cocoa crop
sending the price cocoa beans dramatically higher and suddenly increases the
income of Ghanian farmers. If cocoa farmers set consumption according to the
permanent income hypothesis, we should expect to see,
a. a rise in Ghana’s national savings and an increase in Ghana’s capital
account.
b. a rise in Ghana’s national savings and a decrease in Ghana’s capital
account.
c. a fall in Ghana’s national savings and an increase in Ghana’s capital
account.
d. a fall in Ghana’s national savings and a decrease in Ghana’s capital
account.
________B______
2. Hong Kong has a monetary policy that sets a certain exchange rate with the
United States dollar. Thailand has a monetary policy that selects a certain
domestic interest rate. U.S. dollar interest rates rise temporarily. Assume that
uncovered interest parity holds, we should see that:
a. the Thai currency should appreciate relative to the U.S. dollar and the
velocity of money in Hong Kong should rise.
b. the Thai currency should appreciate relative to the U.S. dollar and the
velocity of money in Hong Kong should fall.
c. the Thai currency should depreciate relative to the U.S. dollar and the
velocity of money in Hong Kong should rise.
d. the Thai currency should depreciate relative to the U.S. dollar and the
velocity of money in Hong Kong should fall.
________C______
3. Income does not increase today, but households expect it to increase in the future.
Under the permanent income hypothesis, this will imply:
a. Consumption will rise and Savings will rise.
b. Consumption will rise and Savings will fall.
c. Consumption will fall and Savings will rise.
d. Consumption will fall and Savings will fall.
________B______
4. We observe a pattern that developing economies experience real exchange rate
appreciations as they grow. Assuming uncovered interest parity is true in the long
run, we should see that for developing economies with fixed exchange rates:
a. PPP-converted GDP grows faster than exchange rate-converted GDP and
inflation will be higher than in the US.
b. PPP-converted GDP grows faster than exchange rate-converted GDP and
inflation will be lower than in the US.
c. PPP-converted GDP grows slower than exchange rate-converted GDP and
inflation will be higher than in the US.
d. PPP-converted GDP grows slower than exchange rate-converted GDP and
inflation will be higher than in the US..
_______C______
5. Assume that Korea and Hong Kong are open to international capital flows. Korea
operates a floating exchange rate in which the interest rate is set according to the
domestic business cycle, while Hong Kong pegs its exchange rate to the US
dollar. If government spending goes up in both countries, our business cycle
model tells us we should expect to see, a
a. fall in interest rates in Hong Kong and exchange rate appreciation in
Korea
b. rise in interest rates in Hong Kong and an exchange rate depreciation in
Korea
c. rise in interest rates in Hong Kong and exchange rate appreciation in
Korea
d. rise in interest rates in Hong Kong and an exchange rate depreciation in
Korea
_____No Answer_________
6. Assume that Korea and Hong Kong are open to international capital flows. Korea
operates a floating exchange rate in which the interest rate is set according to the
domestic business cycle, while Hong Kong pegs its exchange rate to the US
dollar. Assume that the United States Federal Reserve shifts its monetary policy
schedule to increase the target interest rate at all levels of US output. According to
our business cycle model, this policy change should:
a. decrease net exports in Korea and have ambiguous effects on investment
in Hong Kong
b. decrease net exports in Korea and decrease investment in Hong Kong
c. have ambiguous effects on net exports in Korea and decrease investment
in Hong Kong.
d. have ambiguous effects on net exports in Korea and have ambiguous
effects on investment in Hong Kong.
________C______
Short Answer Question (5 points each)
7. Which 2 of the the 3 elements of the impossible trinity are chosen by Hong Kong,
China, and the USA respectively?
1.
2.
China
Independent Interest
Rates
Fixed Exchange Rates
USA
Independent Interest
Rates
Free Capital Flows
Hong Kong
Fixed Exchange Rates
Free Capital Flows
8. The forward exchange rate between the US dollar and the Yen is 120 yen per
dollar and the spot rate is 118 yen per dollar. The US interest rate is 10%. What is
the Japanese interest rate under covered interest parity?
1 i  f
1  i   120118 (1.10)  1.118644068
$
e
Calculations
9. (8 points) The current interest rate in the US is i$ = .04 and Hong Kong has a fixed
exchange rate at eFIX = 7.8. Money demand in Hong Kong is written as
PY
. Assume uncovered interest parity. Calculate velocity when the
M D  .1
i
fixed exchange rate is credible (i.e. eLR = 7.8). Calculate the domestic interest rate
and velocity when forex markets expect a revaluation (eLR = 7.575).
PY
When the fixed exchange rate is credible, it = i$t = .04 and V  D  10 i  2 .
M
When a revaluation is expected, uncovered interest parity suggests
LR
1  i  e FIX 1  i$   7.575 1.04   1.01 and V = 1.
7.8
e
10. (10 points) Assume that a country’s savings level is fixed and equal to S = 100.
In every period, the country’s capital depreciates 100% (i.e. d = 1). Further, the
technology of this economy is described with a Cobb-Douglas production
function.
12
Y  24 K  MPKt 1 
Kt 1
Therefore, the real cost of capital is rck = 1+r where r is the real interest rate. The
level of investment today is next period’s capital stock, Kt+1 = It. The economy is
open so that the real interest rate is equal to the world real interest rate. Calculate
the investment and the current account when the world real interest rate is 20%.
The world real interest rate falls to 5%. Calculate the new level of investment and
the new current account.
Profit maximizing capital sets the marginal product of capital equal to the cost of
2
2
12
 12 
 12 
MPK t 1 
 1  rt  K t 1  I t  
 , CA  100  

K t 1
 1 r 
 1 r 
2
 12 
capital r  .2  K t 1  I t  
  100, CA  0
 1.2 
2
 12 
r  .05  K t 1  
  130.6122449,CA=-30.6122449
 1.05 
11. (14 points) A household lives for two periods and will earn income for two
periods before dying. The income in period 0 is Y0 = 100 and the income in
period 2 is Y1 = 440. Assume a real interest rate of 10%.
a. Calculate the level of consumption and savings in the first period under
the permanent income hypothesis.
The present value of consumption equals the present value of lifetime disposable income
C
(Y  T1 )
C0  1  W  (Y0  T0 )  1
1 r
1 r
C
1 r
C0  C1  C0  0  W  C0 
W
1 r
2r
S0P  (Y0  T0 )  C0
National Savings = SP – T
Y0 = 100, Y1 = 440, T0 = T1 = 0
(440)
1 r
W  (100) 
 500, C0 
W  261.905
1.1
2r
S0P  (100)  C0  161.905
b. The government makes a social welfare payment to the household in the
first period of 100 (T0 = -100), so after tax income in period 0 is 200.
However, to do this, the government must run a deficit of 100. Calculate
the present value of after-tax income for the household. Calculate
consumption and saving of the household under the permanent income
hypothesis. Calculate national saving as the sum of saving by the
household minus the budget deficit.
Y0 = 100, Y1 = 440, T0 = -100, T1 = 0
(440)
1 r
W  (200) 
 600, C0 
W  314.286
1.1
2r
S0P  (200)  C0  114.286
National Savings = SP – T = -214.286
c. Now assume that the government must raise future taxes to pay off the
deficit plus interest. The taxes they impose on the household in the second
period is 110 (T0 = -100, T1 = 110) so that after tax income in the second
period is 330. Calculate consumption, household savings and national
savings in period 0.
Y0 = 100, Y1 = 440, T0 = -100, T1 = 110
(330)
1 r
W  (200) 
 500, C0 
W  261.905
1.1
2r
S0P  (200)  C0  61.905
National Savings = SP – T = -161.905
Graphical Answer
12. (10 points) What happens to a fixed exchange rate regime when a central bank
which is in charge of maintaining the fixed exchange rate also acts to monetize
the debt of the fiscal side of the government. Write one paragraph describing a
first generation currency crisis and use one set of graphs to describe the business
cycle effects of the crisis.
i
1. eLR↑
i
IS
2
.
.
1.
LMP
2
UIP
.
.
Y
2. eFIX↑
eFIX
IF a central bank in charge of maintaining a fixed exchange rate prints money to
purchase government debt it creates more money than is demanded at the equilibrium
interest rate. As people sell the excess money for foreign money, the central bank must
buy this money with its reserves to avoid a depreciation. Eventually it will run out of
foreign reserves and be forced to allow the exchange rate to depreciate. In the periods
when it is running out of reserves, the expectations of a devaluation will push up
domestic interest rates as holders of domestic currency bonds demand high interest rates
to hold an asset whose currency will be devalued. This will have a negative impact on
demand for investment. When the exchange rate does devalue, the IS curve will shift out
as domestic goods become more competitive. If the exchange rate is devalued by enough
(relative to eLR), interest rates may fall relative to its previous level.
e
(14 points) Domestic households become more optimistic about the future increasing
autonomous consumption.
a. Use the business cycle model to show what effects this will have on
output, interest rates, and the exchange rate in a country with flexible
exchange rates.
i
i
LMP
i*
i*
IS’
IS
UIP
e*
Y
e
b. Use the business cycle model to show what effects this will have on
output, interest rates, and the exchange rate in a country with fixed
exchange rates.
i
i
LMP
i*
i*
IS’
IS
Y
UIP
eFIX
e
c. Indicate the response of the different components of demand with an up
arrow indicating a positive response ↑, a down arrow indicating a
negative response ↓, and a question mark indicating a positive response.
Flexible Exchange Rates
↑
?
↓
Consumption
Investment
Net Exports
Fixed Exchange Rates
↑
↑
↓
13. (10 points) Japan, Europe, and the United States all begin to run large budget
deficits. Assuming there are no Ricardian effects, graph the effect of this on world
savings and investment. Using the Metzler diagram, demonstrate the effect of this
on the current account of a relatively small economy.
World
r
r
SW
Small Economy
CA
I
W
r
rW
SW’
IW
S,I
S