ECONOMICS 3200, FALL 2003, ALSTON
STUDY GUIDE FOR MIDTERM # 3 (ALSO SEE THE
QUESTIONS/PROBLEMS AT THE END OF EACH CHAPTER)
Essay Questions and Answers for Chap 19
1. Explain the law of one price and the theory of purchasing power parity. Why doesn’t the
purchasing power parity explain all exchange rate movements? What factors determine long-run
exchange rates?
With no trade barriers and low transport costs, the law of one price states that the price of
traded goods should be the same in all countries. The purchasing power parity theory
extends the law of one price to total economies. PPP states that exchange rates should
adjust to reflect changes in the price levels between two countries. PPP may fail to fully
explain exchange rates because goods are not identical, and price levels include traded and
nontraded goods and services. Long-run exchange rates are determined by domestic price
level relative to foreign price levels, trade barriers, import and export demand, and
productivity.
2. Explain the interest parity condition. What key assumption underlies this condition? What
factors affect the returns on domestic and foreign deposits?
The interest parity condition states that returns on domestic and foreign deposits will be
equal. The key assumption for this condition is capital mobility. The return on domestic
deposits is equal to the domestic interest rate. The return on foreign deposits is equal to the
foreign interest rate minus the expected rate of appreciation of the domestic currency.
3. Explain and show graphically the effect of a decrease in the expected future exchange rate on
the equilibrium exchange rate.
A fall in the expected future exchange rate shifts RF to the right, causing a depreciation of
the domestic exchange rate. RF shifts to the right, from R1F to R 2F. The equilibrium
exchange rate falls from E1 to E2.
4. Explain and show graphically the effect of a decrease in the domestic nominal interest rate due
to a decrease in expected inflation on the equilibrium exchange rate.
The decrease in expected inflation lowers the domestic nominal interest rate, and increases
expected dollar appreciation by more than the fall in the domestic interest rate. Thus, RF
shifts to the left by more than RD, causing the domestic exchange rate to appreciate from E1
to E2.
Essay Questions and Answers for Chapter 20
1)
Explain and demonstrate graphically how a purchase of foreign currency reserves leads to
overshooting of the exchange rate, and describe the long-run behavior of the exchange rate.
A purchase of foreign assets increases the monetary base and money supply, increasing the
price level and decreases the expected appreciation of the domestic currency. The reduction
of the expected appreciation of the domestic currency increases the expected return on
foreign assets, shifting RF to the right. The domestic monetary expansion lowers interest
rates in the short run, shifting RD left, and lowering the exchange rate to E2. As the interest
rate returns to its original value, the exchange rate appreciates to E3. This behavior of the
exchange rate is overshooting.
2)
Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed
exchange rate system. What alternative policies are available to eliminate the overvaluation
of the exchange rate?
As indicated in the graph below, the par value is above the equilibrium value, resulting in
overvaluation of the exchange rate. One approach is to pursue contractionary monetary
policies, raising interest rates and shifting RD to the right. This process continues until
equilibrium at par value is restored. The other alternative is to depreciate the exchange rate.
3)
Describe and show graphically the situation of a speculative crisis against a fixed exchange
rate. What can the central bank do to defend the currency? Indicate this policy graphically.
Why might the alternative of devaluation be preferable?
As seen in the graph below, the par value is above the equilibrium value, resulting in an
overvalued currency. When the speculative attack begins, the expected depreciation of the
domestic currency increases substantially, shifting RF far to the right. Very stringent
monetary policy is needed to increase domestic interest rates enough to defend the
currency, as RD must shift to R D3. The cost to the central bank in terms of the costs of
intervention and the contractionary effect on the economy may make devaluation
preferable.
4)
Explain the operation of the gold standard system. What was the required behavior for
deficit and surplus nations? What were the implications of this behavior for each nation’s
money supply?
Under the gold standard, each country sets the price of gold in terms of the domestic
currency, and the exchange rate is determined by the ratio of these prices. Gold would flow
from deficit to surplus nations, reducing the money supply in the deficit nation and
increasing it in the surplus nation. The money supply changes would change the price
levels in each country in the same direction. Exports from the deficit nation become more
competitive due to deflation, while exports from the surplus nation become less
competitive due to inflation. These adjustments continued until balance of payments
equilibrium was restored. Under the gold standard, nations did not control their money
supplies, as gold discoveries and international gold flows determined domestic money
supplies.
Essay Questions and Answers for Chapter 21
1. Explain and demonstrate graphically how a purchase of foreign currency reserves leads to
overshooting of the exchange rate, and describe the long-run behavior of the exchange rate.
A purchase of foreign assets increases the monetary base and money supply, increasing the
price level and decreases the expected appreciation of the domestic currency. The reduction
of the expected appreciation of the domestic currency increases the expected return on
foreign assets, shifting RF to the right. The domestic monetary expansion lowers interest
rates in the short run, shifting RD left, and lowering the exchange rate to E2. As the interest
rate returns to its original value, the exchange rate appreciates to E3. This behavior of the
exchange rate is overshooting.
2. Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed
exchange rate system. What alternative policies are available to eliminate the overvaluation of
the exchange rate?
As indicated in the graph below, the par value is above the equilibrium value, resulting in
overvaluation of the exchange rate. One approach is to pursue contractionary monetary
policies, raising interest rates and shifting RD to the right. This process continues until
equilibrium at par value is restored. The other alternative is to depreciate the exchange rate.
3. Describe and show graphically the situation of a speculative crisis against a fixed exchange
rate. What can the central bank do to defend the currency? Indicate this policy graphically. Why
might the alternative of devaluation be preferable?
As seen in the graph below, the par value is above the equilibrium value, resulting in an
overvalued currency. When the speculative attack begins, the expected depreciation of the
domestic currency increases substantially, shifting RF far to the right. Very stringent
monetary policy is needed to increase domestic interest rates enough to defend the
currency, as RD must shift to R D3. The cost to the central bank in terms of the costs of
intervention and the contractionary effect on the economy may make devaluation
preferable.
4. Explain the operation of the gold standard system. What was the required behavior for deficit
and surplus nations? What were the implications of this behavior for each nation’s money supply?
Under the gold standard, each country sets the price of gold in terms of the domestic
currency, and the exchange rate is determined by the ratio of these prices. Gold would flow
from deficit to surplus nations, reducing the money supply in the deficit nation and
increasing it in the surplus nation. The money supply changes would change the price
levels in each country in the same direction. Exports from the deficit nation become more
competitive due to deflation, while exports from the surplus nation become less
competitive due to inflation. These adjustments continued until balance of payments
equilibrium was restored. Under the gold standard, nations did not control their money
supplies, as gold discoveries and international gold flows determined domestic money
supplies.
Essay Questions and Answers for Chapter 21 - Appendix
1. Explain the time-consistency problem. What is the likely outcome of discretionary policy?
What are the solutions to the time-consistency problem?
With policy discretion, policymakers have an incentive to attempt to increase output by
pursuing expansionary policies once expectations are set. The problem is that this policy
results not in higher output, but in higher actual and expected inflation. The solution is to
adopt a rule to constrain discretion. Nominal anchors can provide the necessary constraint
on discretionary behavior.
2. Explain the 1992 crisis that led to the breakdown of the European Union’s Exchange Rate
Mechanism. What disadvantages of exchange-rate targeting were exhibited during this crisis?
The 1992 crisis began with Germany raising interest rates in 1990 to stem inflationary
pressures from reunification. This demand shock was immediately transmitted to the other
nations in the exchange-rate mechanism. Thus, these countries did not have independent
monetary policies and were subject to shocks from the anchor country. This gave rise to the
second problem. Speculators bet that these other countries would not want the increased
unemployment resulting from the tight monetary policy. Betting that their commitment was
weak, speculators bet against these currencies, and a number were forced to devalue or
drop out of the ERM. The disadvantages illustrated by this are the lack of independent
policy subjecting member nations to shocks from the anchor nation, and the possibility of
speculative attacks when commitment is felt to be weak.
3. What are the advantages and disadvantages of inflation targeting?
The advantages are that the policy is clear and simple, that a nation can follow an
independent policy with a focus on domestic objectives, that the policy does not rely on a
stable money-income relationship, and that the effects of inflationary shocks are reduced.
The disadvantages are that success of the policy is difficult to judge due to the lag between
policy actions and the ultimate outcome, and that the policy could impose a rigid rule and
lead to larger output fluctuations, although these latter two have not proved to be problems
in countries with an inflation target.
Essay Questions and Answers for Chapter 22
1. Explain the Keynesian theory of money demand. What motives did Keynes think determined
money demand? What are the two reasons why Keynes felt velocity could not be treated as a
constant?
Keynes felt the demand for money depended on income and interest rates. Money was held
to facilitate normal transactions and as a precaution for unexpected transactions. For both
of these motives, money demand depended on income. People also held money as an asset,
for speculative purposes. The speculative motive depends on income and interest rate.
People hold more money for speculative purposes when they expect bond prices to fall,
generating a negative return on bonds. Since money demand varies with interest rates,
velocity changes when interest rates change. Also, since money demand depends upon
expectations about future interest rates, unstable expectations can make money demand,
and thus velocity, unstable.
2. What factors determine the demand for money in the Baumol-Tobin analysis of transactions
demand for money? How does a change in each factor affect the quantity of money demanded?
The factors are real income, the price level, interest rates, and the brokerage cost of shifting
between money and bonds. Increases in real income increase money demand less than
proportionately, since the model predicts scale economies in transactions demand.
Increases in prices increase money demand proportionately, since the demand is for real
balances. The quantity of money demanded varies inversely with interest rates, since
interest is the opportunity cost of holding money. The brokerage fee is the cost of
converting other assets (bonds) into money. An increase in this cost increases money
demand.
3. What factors determine money demand in Friedman’s modern quantity theory? How does each
affect money demand? What determines velocity in Friedman’s theory? What effect do interest
rates have on velocity?
In Friedman’s theory, increases in permanent income increase money demand. Increases
in the returns on bonds relative to money and the returns on equities relative to money
decrease money demand. Increases in the returns on goods relative to the return on money,
which is the expected rate of inflation relative to the return on money, decrease money
demand. Velocity is determined by the ratio of actual to permanent income. As actual
income increases in an expansion, permanent income increases less rapidly, so money
demand increases less rapidly than income, and velocity rises (and vice versa for
contractions). Interest rates do not affect velocity in Friedman’s theory, since the relative
returns on money and other assets are predicted to remain relatively constant.
4. In the liquidity trap the demand for money becomes horizontal. Depict this graphically.
Demonstrate and explain why increases in the money supply do not affect interest rates, and thus
aggregate spending, in the liquidity trap.
The graph should at least have a horizontal line for money demand. There should be an
increase in the money supply, which does not change rates when money demand is
horizontal. Since monetary policy affects aggregate spending by changing interest rates,
aggregate spending is unaffected.
Essay Questions and Answers for Chapter 23
1. Keynes believed that unstable investment caused the Great Depression. Using the simple
Keynesian model, demonstrate graphically and explain how a fall in investment reduces
equilibrium output. What is the impact on equilibrium output?
A fall in investment shifts the C I line down in the graph below, from C I to C I.
Due to the multiplier effect, the fall in output is greater than the fall in investment, as
equilibrium output falls from Y to Y.
2. Equal increases in government spending and taxes increase equilibrium output. Explain and
demonstrate this graphically.
An increase in government spending shifts C  I  G up to C  I  G. Equilibrium output
increases from Y to Y. A tax increase shifts the aggregate demand line down by the mpc
times the change in taxes, reducing Y to Y. Since the shift due to taxes is smaller than the
shift due to the increase in government spending, the net effect is to increase equilibrium
output.
3. The Federal Reserve increases interest rates when they want to reduce aggregate demand to
fight inflation. How do increases in the interest rate reduce aggregate demand?
Increases in interest rates reduce planned investment. The decrease in investment reduces
equilibrium output by a multiple amount due to the multiplier effect. Also, increases in
interest rates increase the value of the dollar, reducing net exports, which reduce aggregate
demand and equilibrium output by a multiple amount.
Essay Questions and Answers for Chapter 24
1. Using the ISLM model, show graphically and explain the effects of a monetary expansion
combined with a fiscal contraction. How do the equilibrium level of output and interest rate
change?
The monetary expansion shifts the LM curve to the right, from LM to LM, and the fiscal
contraction shifts the IS curve to the left, from IS to IS. The equilibrium interest rate
unambiguously falls, while the effect on output is indeterminate. The graph below shows Y
increasing, but that result depends on the way the graph is drawn. Students should know the
outcome cannot be determined unambiguously.
2. Using the ISLM model, show graphically and explain the effects of a monetary contraction.
What is the effect on the equilibrium interest rate and level of output?
The monetary contraction shifts the LM curve from LM to LM. The result is that the
equilibrium level of output falls from Y to Y, and the equilibrium interest rate increases
from i to i.
3. Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the
demand for money is completely insensitive to changes in the interest rate. What is this effect
called?
This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve
affects only interest rates. The level of output is constant at Y. The fiscal expansion shifts
the IS curve rightward, increasing the interest rate from i to i.
4. Show graphically and explain why targeting an interest rate is preferable when money demand
is unstable and the IS curve is stable.
Unstable money demand causes the LM curve to shift between LM and LM. If the money
supply is targeted, output fluctuates between Y and Y. With an interest rate target, output
remains stable at Y. Since the objective is to minimize output fluctuations, targeting the
interest rate is preferable.
5. Using the long-run ISLM model, explain and demonstrate graphically the neutrality of money,
for the case of an increase in the money supply.
The increase in the money supply shifts LM to the right, increasing output to Y, above the
natural rate Y*. The interest rate falls from i to i. Excess demand increases the price level,
reducing the real value of the money supply. The LM curve shifts back until the all
pressure on prices is eliminated by the return to the natural rate of output. The initial and
final levels of output and interest rate are the same. No real variables have changed.
Essay Questions and Answers for Chapter 25
1. Using the ISLM model, show graphically and explain the effects of a monetary expansion
combined with a fiscal contraction. How do the equilibrium level of output and interest rate
change?
The monetary expansion shifts the LM curve to the right, from LM to LM, and the fiscal
contraction shifts the IS curve to the left, from IS to IS. The equilibrium interest rate
unambiguously falls, while the effect on output is indeterminate. The graph below shows Y
increasing, but that result depends on the way the graph is drawn. Students should know the
outcome cannot be determined unambiguously.
2. Using the ISLM model, show graphically and explain the effects of a monetary contraction.
What is the effect on the equilibrium interest rate and level of output?
The monetary contraction shifts the LM curve from LM to LM. The result is that the
equilibrium level of output falls from Y to Y, and the equilibrium interest rate increases
from i to i.
3. Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the
demand for money is completely insensitive to changes in the interest rate. What is this effect
called?
This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve
affects only interest rates. The level of output is constant at Y. The fiscal expansion shifts
the IS curve rightward, increasing the interest rate from i to i.
4. Show graphically and explain why targeting an interest rate is preferable when money demand
is unstable and the IS curve is stable.
Unstable money demand causes the LM curve to shift between LM and LM. If the money
supply is targeted, output fluctuates between Y and Y. With an interest rate target, output
remains stable at Y. Since the objective is to minimize output fluctuations, targeting the
interest rate is preferable.
5. Using the long-run ISLM model, explain and demonstrate graphically the neutrality of money,
for the case of an increase in the money supply.
The increase in the money supply shifts LM to the right, increasing output to Y, above the
natural rate Y*. The interest rate falls from i to i. Excess demand increases the price level,
reducing the real value of the money supply. The LM curve shifts back until the all
pressure on prices is eliminated by the return to the natural rate of output. The initial and
final levels of output and interest rate are the same. No real variables have changed.
Essay Questions and Answers for Chapter 26
1. Explain the traditional interest rate channel for expansionary monetary policy. Explain how a
tight monetary policy affects the economy through this channel.
In the traditional channel, a monetary expansion reduces real interest rates, lowering the
cost of capital and increasing investment spending. The increase in investment increases
aggregate demand. A monetary contraction has the opposite effect, raising real interest
rates, lowering investment and aggregate spending.
2. Explain how expansionary and contractionary monetary policies affect aggregate demand
through the exchange rate channel.
An expansionary monetary policy reduces real interest rates, causing appreciation of the
domestic currency. This depreciation increases net exports and aggregate spending. A
monetary contraction increases real interest rates, reducing net exports and aggregate
spending.
3. Discuss three channels by which monetary policy affects stock prices and aggregate spending.
The answer should include three of the following:
In Tobin’s q theory, a monetary expansion increases stock prices, increasing the value of
the firm relative to the cost of new capital. This stimulates investment in new capital goods,
which in turn increases aggregate spending.
A monetary expansion increases stock prices, increasing wealth and stimulating
consumption and aggregate spending.
Expansionary monetary policy increases equity prices. This improves firms’ balance sheets,
reducing adverse selection and moral hazard and increasing lending for investment, which
increases aggregate spending.
In the household liquidity effect, the increase in equity prices due to a monetary expansion improves
consumer balance sheets, reducing the probability of financial distress, and increasing consumer
spending on durable goods and housing.
Essay Questions and Answers for Chapter 27
1. Explain and show graphically why continuous monetary growth is needed to generate inflation.
Describe how the inflation process is generated.
Only continuous monetary growth can cause continuous increases in aggregate demand of
the sort needed to generate inflation. Other factors can increase demand and the price level,
but none can increase demand continuously. In the graph, the monetary expansion shifts
AD to the right. The increase in output above the natural rate increases wages, shift AS to
the left. Monetary expansion shifts AD repeatedly, and wages continue to adjust.
2. Explain and show graphically how a tax increase reduces demand and increases
unemployment. Why is the speed of the adjustment of wages and/or the role of expectations
important in this situation?
The tax increase shifts AD down from AD1 to AD2. Output falls below the natural rate to Y1,
increasing unemployment. If wages are slow to adjust, the economy remains below the natural
rate for a long time, but adjustment back to the natural rate is rapid if wages adjust quickly or if
expectations lead to rapid adjustment of wages.
3. Explain and show graphically how a positive supply shock, followed by a more restrictive
monetary policy, allows policymakers a painless way to reduce inflation. ANSWER:The positive
supply shock shifts the aggregate supply curve to the right, exerting downward pressure on prices.
Policymakers can now reduce demand to further reducing inflationary pressure without reducing
output below the natural rate. In the figure, prices fall from P0 to P1 due to the positive supply
shock, and fall further to P2 due to the reduction in demand.
Essay Questions and Answers for Chapter 28
1. Demonstrate graphically and explain the short-run and long-run effects of an unanticipated
monetary expansion in the new classical model.
In the new classical model, unexpected monetary expansion shifts AD to the right, as
depicted in the figure. Since this is unexpected, the AS curve does not shift, and output
increases in the short run. As expectations adjust, AS shifts back and output returns to the
natural rate, with only prices rising.
2. Demonstrate graphically and explain the short-run and long-run effects of an anticipated
monetary expansion in the new classical model.
For anticipated policies, AS shifts with ADS, and real output does not change. The only
effect is to increase prices. The economy moves from point 1 to point 3.
3. In the new classical model, show graphically and explain how an expected monetary expansion
that is less than expected reduces real output in the short run. What is the long-run result?
Demand does not increase as much as expected, so AS shifts to the left more than AD shifts
to the right. The result in the short run is a move from point 1 to point 5. In the long-run,
AS adjusts to the actual increase in demand, and equilibrium is at point 3, with higher
prices and no increase in output.
4. In the new Keynesian model, explain and depict graphically why an expected increase in the
money supply increases real output in the short run. What is the long-run result?
Although the increase in demand is expected, rigidities prevent AS from shifting as much
as AD. Thus, short-run real output increases, as the economy moves from point 1 to point
3. In the long run, with complete adjustment, equilibrium is at point 4, with higher prices
and unchanged real output.
5. Explain why anticipated policy has different short-run effects on real output and the price level
in the new classical, new Keynesian, and traditional models. What are the long-run effects of
anticipated policy in each model?
In the new classical model, wages and prices are fully flexible, and expectations are formed rationally. In
the new classical model, an anticipated policy changes results in a matching adjustment of wages and
prices. Thus, AD and AS shift by matching amounts in the opposite direction. This results in no change in
real output, and the largest change in the price level in the short run. In the new Keynesian model,
expectations are rational, but rigidities keep wages and prices from adjusting fully even when policy is
anticipated. Thus, AD shifts by more than AS. As a result, real output and prices both change, with prices
changing by less than in the new classical model. In the traditional model, expectations are formed
adaptively, so policy changes do not affect expectations and AS in the short run. Thus, demand changes
cause the largest changes in real output, and smallest initial price level changes of any of the three models.
In all three models, the long-run result is that real output does not change, and prices adjust fully to changes
in demand.