# ECON 10020/20020 Principles of Macroeconomics Problem Set 6 Solutions

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1 ECON 10020/20020 Principles of Macroeconomics Problem Set 6 Solutions Dennis C. Plott University of Notre Dame Department of Economics April 9,

3 Production and Consumption Without Trade Production With Trade Swords Belts Swords Belts Estonia Morocco Which country has an absolute advantage in producing swords? (A) Estonia A (B) Morocco (C) both countries (D) neither country 2. Which country has an absolute advantage in producing belts? (A) Estonia A (B) Morocco (C) both countries (D) neither country 3. Which country has a comparative advantage in producing swords? (A) Estonia A (B) Morocco (C) both countries (D) neither country 4. Which country has a comparative advantage in producing belts? (A) Estonia (B) Morocco B (C) both countries (D) neither country 5. Prior to trade, what was the opportunity cost to produce 1 belt in Estonia? (A) 1/2 of a sword (B) 4/5 of a sword (C) 1.25 swords (D) 2 swords D 1. A 2. A 3. A 4. B 5. D 3

4 6. Prior to trade, what was the opportunity cost to produce 1 sword in Morocco? (A) 1/2 of a belt (B) 4/5 of a belt B (C) 1.25 belts (D) 2 belts 7. With trade, what is the total gain in belt production? (A) 30 A (B) 80 (C) 120 (D) All of the following are terms of trade that could possibly benefit both countries except (A) 1 belt : 1.33 swords (B) 1 belt : 1.5 swords (C) 1 belt : 1.75 swords (D) 1 belt : 2.25 swords D 9. If the actual terms of trade are 1 belt for 1.5 swords and 70 belts are traded, how many belts will Estonia consume? (A) 50 (B) 70 B (C) 90 (D) If the actual terms of trade are 1 belt for 1.5 swords and 70 belts are traded, how many swords will Morocco gain compared to the without trade numbers? (A) 5 (B) 55 B (C) 105 (D) B 7. A 8. D 9. B 10. B 4

7 21. If a country has a fixed exchange rate, (A) the equilibrium exchange rate in that market does not respond to changes in supply and demand for currency. (B) central banks have more control over real GDP in the economy. (C) central banks must buy and sell their holdings of currencies to maintain a given exchange rate. C (D) the exchange rate is allowed to fluctuate in response to changes in the supply and demand for currency. 22. If the price level in the United States is 110, the price level is 120 in Mexico, and the nominal exchange rate is 140 pesos per dollar, what is the real exchange rate from the U.S. perspective? (A) 94 (B) 115 (C) 128 C (D) The late Hugo Chavez, Venezuela s former president, proposed that the independence of the Venezuelan central bank be eliminated. Given the research on the relationship between central bank independence and inflation, we should expect this event to cause inflation to and the real exchange rate to between the two counties. (Assume the nominal exchange does not change, and that the United States is the domestic country). (A) rise in Venezuela relative to the United States; fall A (B) fall in Venezuela relative to the United States; fall (C) rise in Venezuela relative to the United States; rise (D) fall in Venezuela relative to the United States; rise 24. How might a budget deficit affect the balance of trade? (A) A budget deficit raises interest rates, which raises exchange rates, and increases the balance of trade. (B) A budget deficit raises interest rates, which raises exchange rates, and reduces the balance of trade. B (C) A budget deficit reduces interest rates, which raises exchange rates, and reduces the balance of trade. (D) A budget deficit reduces interest rates, which reduces exchange rates and reduces the balance of trade. 25. If the Fed does not take into account the additional policy channels available in an open economy, then when conducting contractionary monetary policy, (A) it is likely to decrease GDP too much and cause a recession A (B) it is likely to decrease GDP too little and inflation will persist (C) it is likely to increase GDP too much and inflation will persist (D) it is likely to increase GDP too little and cause a recession 21. C 22. C 23. A 24. B 25. A 7

10 36. Which of the following is a drawback to having a common currency across countries, as in the European Union? (A) A common currency increases barriers to trade across countries, reducing opportunities for economic growth. (B) With a common currency, individual countries are no longer able to run independent monetary policies. B (C) Having a common currency implies that the prices of goods across countries must always be the same, regardless of consumer preferences for goods across countries. (D) None of the above is a drawback to a common currency. 37. Pegging a country s exchange rate to the dollar can be advantageous if (A) the country does not trade much with the United States. (B) investors believe the dollar to be more stable than the domestic country s currency. B (C) a country wishes to conduct independent monetary policy. (D) imports are not a significant fraction of the goods the country s consumers buy. 38. Although the pegged exchange rate between the yuan and the dollar has undervalued the yuan, China has been reluctant to abandon the peg for fear that abandoning the peg would (A) increase exports and increase the current account deficit. (B) reduce capital inflows. (C) reduce exports and reduce economic growth. C (D) increase Chinese holdings of dollars. 39. How will the exchange rate (foreign currency per dollar) respond to an increase in preference for imported goods in the United States in the long run? (A) Exchange rates will rise. (B) Exchange rates will fall. B (C) Exchange rates will be unaffected by changes in the relative rate of productivity growth in the United States, both in the short run and in the long run. (D) The exchange rate will be affected in the short run, but not in the long run. 40. Dumping refers to (A) selling inferior products to unsuspecting consumers. (B) selling a product for a price below its cost of production. B (C) exporting products that do not meet domestic safety standards. (D) illegally avoiding tariffs by selling products on the black market. 36. B 37. B 38. C 39. B 40. B 10

11 41. The Wall Street Journal 1 reports New Zealand s agriculture-rich economy has been aided by a surge in demand from Asia s growing middle classes for dairy products thereby increasing exports (EX). New Zealand is a small open economy with a floating exchange rate that currently has a trade deficit. (a) [10 points] Use the open loanable funds (goods) market to show graphically, ceteris paribus, what effects, if any, the change in exports would have on New Zealands : (i) net exports; (ii) output/income; (iii) quantity of saving; (iv) quantity of investment; and (v) the real world interest rate in the short-run. State explicitly what happens to each of the variables; i.e., increase, decrease, unchanged, or ambiguous. Carefully explain your (positive economic) reasoning. r S 1 S 2 r w 1 I 1 S 1 S 2 I 1 S, I EX ceteris paribus NX Y =C+I+G+NX Y S=Y C G desired saving curve shifts rightward (i) NX > 0 This is consistent with S I = NX with the quantity of saving increasing and quantity of investment unchanged. Graphically the trade deficit has been reduced; i.e., smaller gap. (ii) Y > 0 (iii) S > 0 (iv) I = 0 (v) r w = 0 small open economy ; i.e., does not affect the real world interest rate 1 The Wall Street Journal New Zealand Raises Interest Rates as Inflationary Pressure Increases by Howard 23 rd April

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