Professor S. McCafferty
Practice Problems II
Solutions
1. Assume the following Balance of Payments statistics for a hypothetical country:
Current Account
Net Exports
Exports
Merchandise
Services
Imports
Merchandise
Services
Net Income from Assets
Income Receipts on Investments
Income Payments on Investments
Net Unilateral Transfers
60
40
20
-40
-35
-5
Capital and Financial Account
Increase in U.S.-owned Assets Abroad
U. S. Official Reserve Assets
Other U.S. Assets
Increase in Foreign-owned Assets in U.S.
Foreign Official Assets
Other Foreign Assets
Statistical Discrepancy
a.) Calculate the Merchandise Trade Balance.
Merchandise Exports - Merchandise Imports = 40 - 35 = 5
b.) Calculate Net Exports.
NX = Exports - Imports = 60 - 40 = 5
a.) Calculate the Official Settlements Balance.
OSB = Increase in U.S. official reserve assets
- increase in foreign reserve assets
= -5 - 0 = -5
10
-5
-5
5
-40
0
10
?
2
d.) Calculate the Capital Account Balance.
KFA= 5 - 40 + 0 + 10 = -25
e.) Calculate the Statistical Discrepancy.
SD = -(CA + KFA) = -(20 - 25) = 5
2. For this problem, assume that the domestic price level is equal to $12 and that the
foreign price level is equal to £ 2.00 (£ is the symbol for British Pounds, the U.K.
currency). Also assume, for parts a, that the real exchange rate is equal to 1.5.
a.) Calculate the nominal exchange rate of the dollar with respect to the British
Pound. Show your calculation.
e
enom P
P
 enom  e  For
PFor
P
enom  (1.5) 
£2.0
£
 0.25
$12
$
b.) Suppose that the U.S. and British price levels remain constant. What nominal
exchange rate between the U.S. dollar and the British Pound would correspond to
Purchasing Power Parity? Explain briefly.
e  1  e nom  (1.0) 
£2.0
£
 0.167
$12
$
3
3. For this problem, assume that the United States is a large open economy. Also
assume that U.S. and Rest of the World assets are perfect substitutes.
a.) In the graphs below, show the effects of a temporary increase in U.S. government
spending. Does this disturbance move the domestic (U.S.) economy in the
direction of a current account deficit or surplus? What are the effects on domestic
saving and investment?
r
r
SUd .S .
d
S ROW
r1w
r0w
r0w
I Ud .S .
d
I ROW
S, I
United States
CA moves into deficit.
U.S. Savings and Investment both decline.
S, I
Rest of the World
4
b.)
In the graph below, show the effect of this disturbance (the temporary increase
in U.S. government spending) on the U.S. real exchange rate. Does the real
exchange rate appreciate or depreciate? Explain briefly.
e: U.S. Real Exchange Rate
NCO: Dollar Supply
e1
e0
NX: Dollar Demand
The U.S. Real Exchange Rate appreciates.
4. For this question, assume that real money demand is given by:
L
Y
.
i
Also suppose that real income is equal to 1,000, the real rate of interest is equal to 1%,
the expected rate of inflation is zero, and the nominal money supply is 20,000.
a.) Calculate the equilibrium price level.
P
M
20,000
20,000


 2.
L  1,000  10,000


 0.01 
b.) Now suppose that the nominal money supply rises to 40,000, but that the expected
rate of inflation remains equal to zero. What is the new equilibrium price level?
Explain briefly.
P
M
40,000
40,000


4
L  1,000  10,000


 0.01 
5
c.) Suppose instead that the nominal money supply remains equal to 20,000, but that
the expected rate of inflation rises to 3%. What is the new equilibrium price
level? Explain briefly.
P
M
20,000
20,000


4
L 
1,000
 1,000


0.2
 0.01  0.03 
5. Assume that the real money demand is given by:
L  0.2  Y  1000  (r   e )
Also suppose that real income is equal to 1000 and that growth in real income is zero.
Assume that the real interest rate is constant at 10%. Finally suppose that the nominal
money supply is currently 100 and that it is expected to grow at 5% per year.
a.) If the public fully understands that the inflation process is generated by equality
of money supply and money demand, what is the likely value for the expected
rate of inflation in this case?
e 
P M
Y

 Y
 5%  0%  5%
P
M
Y
It is therefore reasonable to assume that if the public understands the inflation
process, they will expect inflation equal to 5% per year. Therefore,  e  5% .
b.) Calculate real money demand in this economy.
Md
 L  0.2 1,000  1,0000.10  0.05  50
P
c.) If the money market is in equilibrium in this economy, what is the current price
level?
P
M 100

2
L
50
6
d.) Suppose that the government announces that the growth rate of the money supply
is permanently falling to 0%. Further assume that everyone believes this
announcement. What is the new equilibrium price level, immediately after the
announcement?
P M
Y

 Y
 0%  0%  0%
P
M
Y
L  0.2 1,000   1,000 0.10   100
e 
P
M 100

1
L 100
6. Assume that real money demand is given by:
L  1000  0.25Y  10,000i.
Also suppose that real income is equal to 4,000, the nominal rate of interest is equal to
10%, and that the price level is 2. Finally, assume that total wealth in the economy is
equal to 10,000.
a.) Calculate real money demand.
L  1,000  0.254,000  10,0000.10  1,000
b.) Calculate nominal money demand.
Md 
Md
 P  L  P  1,0002   2,000
P
c.) Calculate the velocity of money in this economy.
V
PY 24,000 8,000


4
M
2,000
2,000
d.) Calculate the nominal demand for non-monetary assets in this economy.
NM d  Wealth  M d  10,000  2,000  8,000
7
7. Assume that the real money demand is given by:
L
0.25Y
r e
Also suppose that real income is equal to 200 and that growth in real income is zero.
Assume that the real interest rate is constant at 15%. Finally suppose that the nominal
money supply is currently 500 and that it is expected to grow at 5% per year.
a.) If the public fully understands that the inflation process is generated by equality
of money supply and money demand, what is the likely value for the expected
rate of inflation in this case?
e 
P M
Y

 Y
 5%  0%  5%
P
M
Y
b.) Calculate real money demand in this economy.
L
0.25200  50  250
0.15  0.05 0.2
c.) If the money market is in equilibrium in this economy, what is the current price
level?
P
M 500

2
L 250
d.) Suppose that the government announces that the growth rate of the money supply
is permanently rising to 10%. Further assume that everyone believes this
announcement. What is the new equilibrium price level, immediately after the
announcement?
P M
Y

 Y
 10%  0%  0.10
P
M
Y
0.25200  50  200
L
0.15  0.10 0.25
M 500
P

 2.5
L 200
e 
8
8. Use a copy of the diagram below to demonstrate the effects of the following
disturbances on the equilibrium price level as predicted by the classical model.
a.) A permanent, favorable supply shock.
Permanent Increase in A  Y  and r  0  L  P 
P
M
PL(Y, r + e, im)
P
M, Md
9
b.) An increase in expected inflation.
 e  r   e  L  P 
P
M
PL(Y, r + e, im)
P
M, Md
10
c.) A reduction in the money supply.
M  P 
P
M
PL(Y, r + e, im)
P
M, Md
d.) An increase in the interest rate paid on money.
i m  L  P  : same as in part (a).
11
9. For each of the following, identify whether the variable in question is procyclical (P),
countercyclical (C), or acyclical (A). Also indicate by 'Yes' if there is a significant
difference of opinion on any of the cyclical properties and 'No' if there is none.
Variable
Government
Spending
Consumption
Investment
Nominal Interest
Rate
Real Wages
Productivity
Real Interest Rate
Money Growth
Unemployment
Inflation
Cyclical
Behavior
P
Controversy?
No
P
P
P
No
No
No
P
P
A or P
P
C
P or C
No
No
Yes
No
No
Yes
10. For the purposes of this question, assume that a typical business cycle contraction
includes all of the following phenomena:
1.)
2.)
3.)
4.)
5.)
6.)
7.)
Reduced Real Output
Reduced Consumption
Reduced Investment
Reduced Real Interest Rate
Reduced Employment of Labor Services
Reduced Real Wage Rate
Reduced Average Labor Productivity
Assume a standard classical macroeconomic model in which there is complete
information. Can a temporary reduction in total factor productivity, A, explain all of
these phenomena? Answer YES or NO. Carefully explain which (if any) of the
above phenomena this kind of shock CANNOT explain. Use the diagrams provided.
In answering this question assume that the nominal money supply is fixed.
Answer: NO
Reduced Real Interest Rate Cannot be Explained
12
w
NS
w1
w2
ND
N
N 2 N1
Y
Y1
Y  A F (K , N )
Y2
(Y1 / N1 )
(Y2 / N 2 )
N
N 2 N1
r
Sd
r2
r1
Id
I 2  S2
I 1  S1
I, S