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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 2r 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 2r 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 2r 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 2r 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