Problem Set 8
Professor Nordhaus and staff
Economics 122: Fall 2013
Due: Wednesday, December 4 in class
Problem Set 8 (graded) Revised
Do all problems. You can choose to do four of five problems, and the four will be
graded. Feel free to do all five. Note revisions below. We revised because the material
that is struck out was not adequately covered in class or in the readings. Sorry.
Make sure you provide the names of those you worked with. If you did not work with
anyone, state, “I worked on this problem alone.” If you do not answer this, your
problem set will not be graded.
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1. Some puzzlers.
(To answer this question, you need to read Chapter 13 in Mankiw. The material on
a small open economy is slightly different from what we did in class.)
Use the Mundell-Fleming model for a small open economy to predict what would
happen to short-run aggregate output, the exchange rate, and net exports for each
of the following shocks:
a. Congress unexpectedly declares that all government spending should be
cut by 10%, with a flexible exchange rate.
b. A sharp decline in housing prices (such as in 2007-09) leads to a decline in
consumer wealth, with flexible exchange rates.
c. American consumers fall in love with European clothing, with a flexible
exchange rate.
d. Same as (c), with fixed exchange rates.
2. Trilemmas around the world. Be brief on each of the following.
a. Define the trilemma of international finance in your own words in one
sentence.
b. Give an example of something that is impossible according to the IT. Be specific
(i.e., pick a country and an impossible set of policies).
c. You are the chief economist of Belgium, which is part of the Eurozone. Prime
Minister Looser is running for reelection. The PM is committed to stay in the
Eurozone and to continue with open financial markets. The PM’s political
advisers have decided that they will advocate a radical new idea for Belgium:
to use monetary policy to stabilize the economy. Analyze briefly this proposal
and make a recommendation to the PM whether to adopt this idea from the
political advisers.
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3. Krugmanomics
Paul Krugman (who won the Nobel Prize in Economics for his work on
international trade and globalization) has been a harsh critic of Chinese exchange
rate policy. He has argued that the Chinese policy of pegging the Chinese currency
to the U.S. dollar at an artificially low exchange rate has the effect of raising U.S.
unemployment. Do you agree? Explain. Assume for your answer that the U.S. and
China are the only two countries in the world.
4. The strange macroeconomics of quotas
The US current account has had a large trade deficit in recent years. There have
been proposals to put tariffs or quotas on imports. (A quota is a quantitative limit
on imports, such as a limit of 2 million automobiles per year.)
a. Show the impact of an import quota on GDP and the trade balance under
flexible exchange rates for a small open economy.
b. Answer (a) for fixed exchange rates.
c. Extra credit: Answer (a) and (b) for a large open economy.
5. Debt and growth
a. Read the interesting analysis of the President’s Council of Economic
Advisers (CEA) on the impact of deficits on economic growth (see below),
primarily pp. 85-87 but you should skim the rest. This shows how our
economic growth models are actually used in economic policy.
b. Show an economic model that will explain the CEA’s reasoning. Use
algebra and/or a spreadsheet to replicate the results, in particular chart 215, which compares the two scenarios described. Note that the chart refers
to the difference between the economy with and without the policy.
Assume that the rate of population growth is 0%, and that technological
change is exogenous.
c. Give one important criticism of the model, and explain it carefully.
* http://www.econ.yale.edu/~nordhaus/homepage/documents/ERP94.pdf
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