Economics 502
Professor S. McCafferty
Practice Problems II
1. 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 part 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.
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.
2. For this problem, consider the case of a temporary worldwide increase in total factor
productivity ( A) .
a.) First consider the impact on the world economy. In the graphs below, show the
effects of this disturbance. Does the world real interest rate increase or decrease?
Does the level of world investment increase or decrease? Explain briefly.
rw
Sd
r1w
Id
S, I
S1  I 1
World Economy
2
b.) Now consider a very small economy that is part of this world economy. Again
assume that there has been a temporary worldwide increase in total factor
productivity. However, in this small economy, there is no change in total factor
productivity. Show the effects of this worldwide disturbance in the diagram
below. Does this disturbance move the domestic economy in the direction of a
current account deficit or surplus? What are the effects on domestic saving and
investment?
r
d
S Home
r1w
d
I Home
S1  I 1
S, I
Domestic Small Open Economy
3
c.) Now consider the case of a large open economy, the U.S., for example. Suppose
that foreign total factor productivity has temporarily increased, but that U.S. total
factor productivity is unchanged. Does this disturbance move the U.S. in the
direction of a current account deficit or surplus? What are the effects on U.S.
savings and investment? What is the effect on the world real interest rate?
Explain briefly.
r
r
SUd .S .
d
S ROW
r1w
r1w
I Ud .S .
d
I ROW
S, I
S, I
S1  I 1
United States
Rest of the World
4
d.) For this part of the question, continue to assume that the U.S. is a large open
economy. In the graph below, show the effect of this disturbance (the temporary
increase in foreign total factor productivity) on the U.S. price level. Explain
briefly.
P
M
PL(Y, r + e, im)
P
M, Md
5
e.) For this part of the question, continue to assume that the U.S. is a large open
economy. In the graph below, show the effect of this disturbance (the temporary
increase in foreign A) on the U.S. real exchange rate. Does the real exchange
rate appreciate or depreciate? Explain briefly.
e: U.S. Real Exchange Rate
NFI: Dollar Supply
e0
NX: Dollar Demand
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
r0w
r0w
I Ud .S .
d
I ROW
S, I
United States
S, I
Rest of the World
6
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
NFI: Dollar Supply
e0
NX: Dollar Demand
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.
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.
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.
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5. 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.
b.) Calculate nominal money demand.
c.) Calculate the velocity of money in this economy.
d.) Calculate the nominal demand for non-monetary assets in this economy.
6. 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?
b.) Calculate real money demand in this economy.
c.) If the money market is in equilibrium in this economy, what is the current price
level?
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?
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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?
b.) Calculate real money demand in this economy.
c.) If the money market is in equilibrium in this economy, what is the current price
level?
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?
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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.
b.) An increase in expected inflation.
c.) A reduction in the money supply.
d.) An increase in the interest rate paid on money.
P
M
PL(Y, r + e, im)
P
M, Md
10
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
Cyclical
Behavior
Controversy?
Government
Spending
Consumption
Investment
Nominal Interest
Rate
Real Wages
Productivity
Real Interest Rate
Money Growth
Unemployment
Inflation
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 diagrams where
appropriate. In answering this question assume that the nominal money supply is
fixed.