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CHAPTER 29 - EXCHANGE RATES AND MACROECONOMIC POLICY PROBLEM SET 2. a. Setting the quantity of pounds demanded equal to the quantity supplied, we have 10 – 2e = 4 + 3e 6 = 5e e = 6/5, or 1.2 dollars per pound. b. After the U.S. government intervenes, the demand for pounds equation becomes 12 – 2e. Resolving for equilibrium, the exchange rate climbs to 1.6 dollars per pound, a depreciation of the dollar. The U.S. government might intervene in this way if it wanted to help its export-oriented industries. 4. Dollars per Peso S1 pesos pesos S2 e1 D1 e2 D2 pesos pesos Quantity of pesos a. As the U.S. interest rate rises, causing a and I to fall, U.S. GDP decreases. The interest rate increase also makes U.S. assets more attractive to Americans and to Mexicans. This, combined with the fall in U.S. GDP, causes the demand curve for Mexican pesos to shift leftward and the supply curve for pesos to shift rightward. The U.S. dollar appreciates. b. The U.S. dollar appreciation causes net exports to fall, further shrinking equilibrium GDP in the U.S. c. If the Mexican central bank raised its interest rates just as much as the United States, then the dollar would not appreciate as much. (It might still appreciate somewhat, depending on the relative decline in U.S. and Mexican GDP, and the impact of these declines on U.S. net exports). While U.S. output would still fall, it would not fall as much as in the initial analysis. Chapter 29 Exchange Rates and Macroeconomic Policy 6. a. b. A fixed rate of 1.41 dinars per dollar is the equivalent of $0.71 per dinar. Since this is higher than the market equilibrium price of $0.50 per dinar, Jordan’s central bank must buy dinars to keep the dinar from depreciating. c. Jordan would eventually run out of foreign reserves, and so could not buy dinars forever. d. An expected fall in the dinar causes the supply curve for dinars to shift rightward from S1 to S2and the demand curve to shift leftward D1 to D2. e. The end result is that Jordan’s central bank must buy even more dinars to maintain the fixed rate. Chapter 29 Exchange Rates and Macroeconomic Policy 8. 10. Since Country B has the higher inflation rate, its relative price level is rising. As its basket of goods becomes relatively more expensive, only a depreciation of its currency can restore purchasing power parity. Traders would buy Country A’s currency in order to buy its goods for resale in Country B. Country A’s currency will appreciate relative to Country B’s (alternately stated: Country B’s currency will depreciate relative to Country A’s). Since the trade deficit at point B equals 2,000 billion yen, and since the exchange rate is $0.01 per yen, the trade deficit measured in dollars is 2,000 billion x $0.01 = $20 billion. MORE CHALLENGING QUESTIONS 12. a. The rise in China’s price level, assuming no change in the U.S. price level, will increase Chinese demand for U.S. goods. The supply of Yuan will increase as Chinese increase demand for dollars to buy U.S. goods. b. At the same time, the relatively higher price level in China will reduce demand by U.S. residents for Chinese goods. The demand for Yuan will decrease. c. The combined effect of an increased supply of Yuan and a decreased demand for Yuan will be a fall in the price of the Yuan. d. The falling price of the Yuan will reduce the level of undervaluation of the fixed rate of $0.15 per Yuan.