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Econ 100B
Macroeconomic Analysis
Professor Steven Wood
Spring 2013
Problem Set #6 ANSWERS
Due: April 30, 2013 in class at 2:10 p.m.
(The grace period ends promptly at 2:20:01 p.m.)
Place your completed problem set in the box near the entrance.
Please sign the following oath:
The answers on this problem set are entirely my own work. I neither copied from the work of others nor allowed
others to copy from my work.
_______________________________________
Signature
Any problem set turned in without a signature will be assigned a grade of zero.
Problem Set Instructions
1.
You MUST complete your problem set on this template.
2.
Your answers to the multiple choice questions MUST be computer highlighted.
3.
Graphs and equations MAY be drawn by hand. When drawing diagrams, clearly and accurately label all axis,
lines, curves, and equilibrium points.
4.
Explanations MUST be word-processed. Your explanations should be succinct and to the point.
Problem Set #6 (Spring 2013)
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A. Multiple Choice Questions (15 points). Computer highlight the best answer (3 points each).
1.
Suppose that a haircut in Berkeley costs $20, while the price for the same haircut in Mumbai, India is 600
Indian rupees (Rs.). At which nominal exchange rate is the dollar price lower for the Mumbai haircut?
a.
b.
c.
d.
2.
Suppose an item sells for $125 in the United States and for 62,500 pesos in Chile. According to the law of
one price, the nominal exchange rate (pesos/dollar) should be:
a.
b.
c.
d.
3.
The actual value of the U.S. dollar will fall.
The actual value of the U.S. dollar will rise.
The actual value of the U.S. dollar will not be affected.
What happens to the actual value of the U.S. dollar cannot be determined.
The purchase of foreign currency by a central bank will tend to cause:
a.
b.
c.
d.
5.
0.002
500
31,313
Either $125 or 62,500 pesos, but not both.
Taken by itself, if participants in the foreign exchange markets come to expect an increase in the value of
the U.S. dollar:
a.
b.
c.
d.
4.
$0.04/Rs.
$0.029/Rs.
20Rs./$
25Rs./$
An appreciation of the domestic currency.
A depreciation of the domestic currency.
An increase in the value of foreign exchange, but no change in the value of the domestic currency.
A decrease in the value of foreign exchange, but no change in the value of the domestic currency.
Suppose that a country has adopted a fixed exchange rate. If an appreciation in the value of the country's
currency begins to develop, then, in order to maintain the fixed exchange rate, the monetary authorities
must:
a.
b.
c.
d.
Sell the anchor currency.
Buy the anchor currency.
Buy the domestic currency.
Raise the domestic real interest rate.
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B. Analytical Question (35 points). Answer the following question based on the standard models of analysis developed in class. The information in the various
parts of the question is sequential and cumulative.
1.
The Open Economy AD/AS Model with a Foreign Exchange Market. Suppose that the French economy, which is characterized by perfect capital
mobility and sticky wages and prices, is at potential output with a fixed exchange rate with Germany. The French central bank is firmly committed to
maintaining the fixed exchange rate at its initial equilibrium value.
a.
Based only on this information, use an AD – AS diagram (on the left) and a Foreign Exchange diagram (on the right) to clearly and accurately
show the French economy’s initial (1) economic output, (2) inflation, and (3) equilibrium exchange rate (using a direct quotation). These
diagrams should be drawn in BLACK.
π
E (G/F)
LRAS
SRAS2(πe = π1)
SRAS0(πe = π0) =
SRAS1(πe = π0)
π2
SRAS2a(πe = π0)
π1
π0
SRAS1a(πe = π0)
SF0
E1a
E2a
E1 = E0
π1a
AD2
DF1a
DF2a
AD1a
Y1a
Problem Set #6 (Spring 2013)
YP
Y1 Y2
AD0
Y
AD2a AD1
DF0 = DF1 = DF2
QF
QF
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b. Now suppose that in Year 1, the German government engages in a large fiscal contraction. Based only
on this additional information, clearly and accurately show in your diagrams above the Year 1
effects of this German fiscal contraction on French (1) economic output, (2) inflation, and (3) the
exchange rate. These effects should be drawn in RED.
c.
Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to (1) economic output, (2) inflation, (3) the exchange rate, and (4) net exports
and explain why these changes take place.
The large fiscal contraction by Germany in Year 1 would reduce planned spending and
aggregate demand in Germany. This can be represented by a leftward shift of the German IS
and AD curves. This would result in lower German economic output, lower German inflation,
and a lower German real interest rate (as the central bank responded according to the Taylor
Principle).
A lower German real interest rate increases the attractiveness of French currency denominated
assets. As a result, the demand for French currency denominated assets would increase. This
can be represented by a rightward shift of the demand curve for French currency denominated
assets from DF0 to DF1a. This would result in an appreciation of the French currency from E0 to
E1a.
The appreciation of the French currency from E0 to E1a increases the cost of French goods in
Germany, reducing the German demand for French goods and reducing French exports to
Germany. In addition, the appreciation of the French currency from E0 to E1a decreases the cost
of German goods in France, increasing the French demand for German goods and increasing
French imports from Germany. Consequently, French net exports have declined, reducing
planned expenditures and aggregate demand. This can be represented by a leftward shift of the
French AD curve from AD0 to AD1a.
In addition, because the appreciation of the French currency from E0 to E1a reduces the costs of
German imports in France it is also a positive short-run aggregate supply shock for France.
This can be represented by a downward (or rightward) shift of the short-run aggregate supply
curve from SRAS0(πe = π0) to SRAS1a(πe = π0).
The net result of this appreciation of the French currency from E0 to E1a is lower French
economic output, lower French inflation, and a lower French real interest rate (as the central
bank responded according to the Taylor Principle).
However, the French central bank is firmly committed to maintaining the fixed exchange rate at
its initial equilibrium value. In order to bring the French currency back to its initial value of E0,
the French central bank would have to engage in a discretionary monetary policy expansion,
reducing the real interest rate at every inflation rate. This can be represented by a rightward
(or downward) shift of the MP curve and a rightward shift of the AD curve from AD1a to A1.
The lower French real interest rate would make French currency denominated assets less
attractive relative to German currency denominated assets. As a result, the demand for French
currency denominated assets would decrease. This can be represented by a leftward shift of the
demand curve for French currency denominated assets from DF1a to DF1. The decline in the
French real interest rate must match the decline in the German real interest rate in order to
restore the relative attractiveness of French versus German currency denominated assets.
Consequently, DF1 will equal DF0 and the French currency would depreciate from E1a to E1 = E0.
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With the depreciation of the French currency from E1a to E1 = E0, the downward shift of the
short-run aggregate supply curve from SRAS0(πe = π0) to SRAS1a(πe = π0) is completely reversed
and the short-run aggregate supply curve shifts upward (or leftward) from SRAS1a(πe = π0) to
SRAS1(πe = π0) = SRAS0(πe = π0). In addition, the leftward shift of the aggregate demand curve
from AD0 to AD1a is more than completely reversed because the lower French real interest rate
also stimulates consumer and investment spending so that the aggregate demand curve shifts
rightward from AD1a to AD1 > AD0.
The net result is an increase in French economic output from YP to Y1, an increase in French
inflation from π0 to π1, but a lower French real interest (to match the decline in the German real
interest rate).
d. On your diagrams above, clearly and accurately show the Year 2 effects of (1) economic output, (2)
inflation, and (3) the exchange rate. These effects should be drawn in BLUE.
e.
Provide an economic explanation of what you have drawn in your diagrams above. Be sure to
discuss what happens to (1) economic output, (2) inflation, (3) the exchange rate, and (4) net exports
and explain why these changes take place.
Because French economic output is above its potential output level, the French short-run
aggregate supply curve shifts up from SRAS1(πe = π0) to SRAS2(πe = π1), increasing French
inflation. Higher French inflation causes the French central bank to increase the French real
interest rate according to the Taylor Principle.
In addition, because German economic output is below its potential output level, German
inflation will decline, causing the German central bank to reduce the German real interest rate
according to the Taylor Principle.
As a result of a higher French real interest rate and a lower German real interest rate, the
demand for French currency denominated assets increases. This can be represented by a
rightward shift of the demand curve for French currency denominated assets from DF1 to DF2a.
This would result in an appreciation of the French currency from E1 (= E0) to E2a.
The appreciation of the French currency from E1 to E2a increases the cost of French goods in
Germany, reducing the German demand for French goods and reducing French exports to
Germany. In addition, the appreciation of the French currency from E1 to E2a decreases the cost
of German goods in France, increasing the French demand for German goods and increasing
French imports from Germany. Consequently, French net exports have declined, reducing
planned expenditures and aggregate demand. This can be represented by a leftward shift of the
French AD curve from AD1 to AD2a.
In addition, because the appreciation of the French currency from E1 to E2a reduces the costs of
German imports it is also a positive short-run aggregate supply shock. This can be represented
by a downward (or rightward) shift of the short-run aggregate supply curve from SRAS2(πe =
π0) to SRAS2a(πe = π0).
The net result of this appreciation of the French currency from E1 to E2a lower French economic
output, lower French inflation, and lower French real interest rates (as the central bank
responded according to the Taylor Principle).
Problem Set #6 (Spring 2013)
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However, the French central bank is firmly committed to maintaining the fixed exchange rate at
its initial equilibrium value. In order to bring the French currency back to its initial value of E0,
the French central bank would have to engage in another discretionary monetary policy
expansion, reducing the real interest rate at every inflation rate. This can be represented by a
rightward (or downward) shift of the MP curve and a rightward shift of the AD curve from
AD2a to A2.
The lower French real interest rate would make French currency denominated assets less
attractive relative to German currency denominated assets. As a result, the demand for French
currency denominated assets would decrease. This can be represented by a leftward shift of the
demand curve for French currency denominated assets from DF2a to DF2. The decline in the
French real interest rate must match the decline in the German real interest rate in order to
restore the relative attractiveness of French versus German currency denominated assets.
Consequently, DF2 will equal DF0 and the French currency would depreciate from E2a to E2 = E0.
With the depreciation of the French currency from E2a to E2 = E0, the downward shift of the
short-run aggregate supply curve from SRAS2(πe = π1) to SRAS2a(πe = π1) is completely reversed
and the short-run aggregate supply curve shifts upward (or leftward) from SRAS2a(πe = π1) to
SRAS2(πe = π1). In addition, the leftward shift of the aggregate demand curve from AD1 to AD2a
is more than completely reversed because the lower French real interest rate also stimulates
consumer and investment spending so that the aggregate demand curve shifts rightward from
AD2a to AD2 > AD1.
The net result is an increase in French economic output from Y1 to Y2, an increase in French
inflation from π1 to π2, but a lower French real interest (to match the decline in the German real
interest rate).
Problem Set #6 (Spring 2013)
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