Econ Spring 2007 Homework 5

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1 Econ Spring 2007 Homework 5 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) The real exchange rate, q, is defined as A) E times P B) E times P C) E D) (E times P )/P E) P/(E times P ) 1) 2) Which one of the following statements is the most accurate? A) A rise in domestic real income raises aggregate demand for home output. B) A rise in domestic real income keeps aggregate demand for home output at the same level. C) A rise in domestic real income decreases aggregate demand for home output because of the increase demand for import. D) It is difficult to tell whether a rise in domestic real income affects positively or negatively aggregate demand for home output. 2) 3) Disposable income is defined as: A) Y-T. B) C-T. C) I-C. D) Y-I. E) Y-C. 3) 4) The aggregate demand for home input can be written as a function of: I. Real exchange rate. II. Government spending. III. Disposable income. A) I only B) III only C) I and III D) II and III E) I, II, and III 4) 1

2 5) An increase in the real exchange rate: A) Makes imports more expensive. B) Makes imports less expensive. C) Always makes the number of imports rise. D) Does not affect import values. E) A and D. 5) 6) If the AA-DD model is true, which of the following are true in terms of the current account balance: 6) A) Monetary expansion increases the current account balance. B) Fiscal expansion increases the current account balance. C) Monetary expansion decreases the current account balance. D) Fiscal expansion decreases the current account balance. E) Both A and D. 7) In the short run: A) Monetary expansion causes the current account balance (CAB) to decrease & fiscal expansion causes the CAB to increase. B) Monetary expansion causes the CAB to increase & fiscal expansion causes the CAB to increase. C) Monetary expansion causes the CAB to decrease & fiscal expansion causes the CAB to decrease. D) Monetary expansion causes the CAB increase & fiscal expansion causes the CAB to decrease. E) Monetary expansion causes the CAB to increase & the effects of fiscal expansion are ambigious. 7) 8) Which one of the following statements is the most accurate? A) A permanent decrease in taxes cannot have short-run effects. B) A permanent increase in the money supply cannot have any short -run effects. C) A permanent increase in taxes cannot have any short-run effects. D) A permanent decrease in the money supply cannot have short-run effects. 8) 9) What would be the best description on what happens to real output in the Short run? A) Money prices of goods and services not related to each other. B) Money prices of goods and services vary. C) Money prices of goods are only temporarily fixed. D) Money prices of services are only temporarily fixed. E) C and D. 9) 2

3 10) The DD schedule shows all combinations of which 2 variables so that the output market is in equilibrium? 10) A) Exports and the exchange rate. B) Output and exports. C) Foreign prices and the exchange rate. D) Output and the exchange rate. E) Imports and exports. 11) The amount that a country wishes to consume depends on A) Disposable income B) Import amounts of the country C) Depreciation of the countryʹs currency D) Export amounts of the country 11) 12) Which of the following do not affect the position of the DD curve? A) Monetary policy. B) Export Demand. C) Government spending. D) Taxes. E) Price levels. 12) 13) In the short-run, a rise in the exchange rate, i.e. currency depreciation, A) Raises aggregate demand and lowers output B) Lowers aggregate demand and raises output C) Raises aggregate demand and raises output. D) Lowers aggregate demand and lowers output E) Raises aggregate demand and does not affect output 13) 14) The domestic currency price of a representative domestic expenditure basket is A) P times E, the domestic price level times the domestic price level B) P, the foreign price level C) E, the nominal exchange rate D) P, the domestic price level E) P times E, the foreign price level times the nominal exchange rate 14) 3

4 15) The current account balance is A) The demand for a countryʹs exports less the countryʹs own demand for imports. B) The supply of a countryʹs exports less the countryʹs own demand for imports. C) The demand for a countryʹs exports plus the countryʹs own demand for imports. D) The countryʹs own demand for imports less the demand for a countryʹs exports. 15) 16) Which one of the following statements is most accurate? A) In general, consumption demand rises by less than disposable income. B) In general, consumption demand rises by the same amount as disposable income rises. C) In general, consumption demand rises by more than income. D) In general, consumption demand rises by more than disposable income. E) In general, consumption demand rises by less than income. 16) 17) Which statement best describes the current account balance? A) Monetary expansion keeps the current account balance the same. B) Fiscal expansion increases the current account balance. C) Monetary expansion lowers the current account balance. D) Fiscal expansion keeps the current account balance the same. E) Monetary expansion increases the current account balance. 17) 18) Which of the following compete to determine whether the current account improves or worsens following a rise in the real exchange rate: 18) A) Volume effect and inflation. B) Appreciation and depreciation. C) Crowding Out effect and producers effect. D) Volume effect and value effect. E) Producers effect and value effect. 19) When the real exchange rate rises, A) Imports measured in terms of domestic output will fall. B) Imports measured in terms of domestic output will not be affected. C) Imports measured in terms of domestic output will rise or fall. D) Imports measured in terms of domestic output will rise. 19) 4

5 20) The interest parity condition requires that: A) The money supply is held constant. B) Purchasing power parity hold. C) Interest rates are fixed in the short run. D) There is a unique exchange rate for every output level. E) All countries have the same interest rate. 20) 21) Temporary tax cuts would cause: A) the DD-curve to shift left. B) the AA-curve to shift right. C) the AA-curve to shift left. D) the DD-curve to shift right. E) a shift in the AA-curve, although the direction is ambiguous. 21) 22) In the short-run, any rise in the foreign price level, P, will cause A) An downward shift in the aggregate demand function and a reduction in output B) An upward shift in the aggregate demand function but leaves output intact C) An upward shift in the aggregate demand function and an expansion of output D) An upward shift in the aggregate demand function and a reduction in output E) A downward shift in the aggregate demand function and an expansion of output 22) 23) In the short-run, a reduction in the exchange rate, i.e. currency appreciation, A) Raises aggregate demand and raises output B) Lowers aggregate demand and raises output C) Raises aggregate demand and does not affect output D) Lowers aggregate demand and lowers output E) Raises aggregate demand and lowers output 23) 24) Which one of the following statements is most accurate? A) In the short run, domestic output depends only on the available domestic supplies of factors of production. B) In the long run, domestic output depends only on the available domestic supplies of factors of production. C) In the long run and in the short run, domestic output depends only on the available domestic supplies of factors of production. D) In the long run, foreign output depends only on the available domestic supplies of factors of production. 24) 5

6 25) In the short-run, a temporary increase in the money supply A) Shifts the AA curve to the left, decreases output and depreciates the currency B) Shifts the AA curve to the left, increases output and appreciates the currency C) Shifts the AA curve to the left, increases output and depreciates the currency D) Shifts the DD curve to the right, increases output and appreciates the currency E) Shifts the AA curve to the right, increases output and depreciates the currency 25) 26) In the short-run, a temporary increase in the money supply A) Shifts the AA curve to the left, increases output and depreciates the currency B) Shifts the AA curve to the right, increases output and appreciates the currency C) Shifts the AA curve to the right, increases output and depreciates the currency D) Shifts the AA curve to the left, decreases output and depreciates the currency E) Shifts the AA curve to the left, increases output and appreciates the currency 26) 27) Which one of the following statements is most accurate? A) In the short run, domestic output depends only on the available domestic supplies of factors of production. B) In the long run, foreign output depends only on foreign disposable income. C) In the long run, domestic output depends only on the available domestic supplies of factors of production. D) All of the above. 27) 28) Which one of the following statements is the most accurate? A) An increase in disposable income improves the current account. B) An increase in income worsens the current account. C) An increase in disposable income worsens the current account. D) An increase in disposable income does not affect the current account. E) An increase in income improves the current account. 28) 29) Why is the economy at full employment in the long run? A) Only price can adjust. B) Wages donʹt adjust C) Wages and the price level eventually adjust to develop full employment. D) Prices donʹt adjust. E) Only wages have the ability to adjust. 29) 6

7 30) According to the Timing of a Balance of Payments model, a crisis can only occur at time T because: A) At time Tʹʹ, everyone holding reserves would try to sell them just before this point, but no one would want to buy them because of the imminent appreciation of the home currency. B) At time Tʹʹ, everyone no one holding reserves would want to sell them before this point, but everyone would want to buy them because of the imminent depreciation of the home currency. C) Only at time T are asset markets continually in equilibrium D) Both A and C. E) Both B and C. 30) 31) Australia and Poland managed their exchange rates A) under a managed floating exchange rate regime B) under a fixed exchange rate regime C) under a flexible exchange rate regime D) under a currency board exchange rate regime 31) 32) The interest parity condition can be written as A) R = R /(Ee - E) B) R = R - (Ee - E)/E C) R = R + (Ee + E)/E D) R = R + (Ee - E)/E E) R = R2 - (Ee - E)/E 32) 33) From 1837 and up until the Civil War, the United States adhered to a A) bronze standard B) silver standard C) gold standard D) bimetallic standard 33) 7

8 34) Which one of the following statements is the most accurate? A) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply. B) Under a dirty float exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply or its output. C) Under a flexible exchange rate, central bank monetary tools are powerful and do affect the economyʹs output. D) Under a flexible exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply or its output. E) Under a fixed exchange rate, fiscal policy tools are powerless to affect the economyʹs money supply or its output. 34) 35) A central bankʹs international reserves include A) any silver that it owns B) only foreign and domestic assets C) any silver that it owns and foreign and domestic assets D) any gold that it owns and foreign and domestic assets E) any gold that it owns 35) 36) Why is the reserve center in the reserve currency fixed rate system asymmetric? A) The center country has to intervene all the time and regulate the balance of payments. B) Other countries fix their exchange rate to the reserve currency, and there is no exchange rate left for the reserve center to fix. C) The reserve center fixes its exchange rate against the reserve currency, and all other countries are subject to that rate. D) The center country never has to intervene and bears none of the burden of financing its balance of payments. E) Both B and D. 36) 37) Perfect asset substitutability is the assumption that A) the foreign exchange market is in equilibrium only when domestic assets are risk-free B) the foreign exchange market is in equilibrium only when expected returns on all assets are negative C) the foreign exchange market is in equilibrium only when expected returns on foreign currency bonds are greater than returns on domestic assets D) the foreign exchange market is in equilibrium only when expected returns on domestic assets are equal to returns on foreign currency bonds E) the foreign exchange market is in equilibrium only when expected returns on domestic assets are greater than returns on foreign currency bonds 37) 8

9 38) Which one of the following statements is most true? A) Any central bank purchase of assets results in an increase in the domestic money supply, while any central bank sale of assets causes the money supply to decline. B) Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline. C) Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline. D) Any central bank purchase of assets automatically results in a decrease in the domestic money supply, while any central bank sale of assets automatically causes the money supply to increase. E) N f th b tt ti t 39) When a countryʹs currency is devalued: A) Output decreases. B) Output increases. C) The money supply decreases. D) The money supply increases. E) Both B and D. 38) 39) 40) The liabilities side of a central bank include A) currency in circulation B) deposits held by the private banks C) deposits held by the private banks, foreign assets, and currency in circulation D) deposits held by the private banks and currency in circulation E) None of the above 40) 41) Which one of the following statements is most true? A) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in a foreign central bankʹs claims on the home country implies a decreased foreign money demand. B) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated decrease in a foreign central bankʹs claims on the home country implies a decreased foreign money supply. C) If central banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in a foreign central bankʹs claims on the home country implies a decreased foreign money supply. D) There is not a clear connection between the two. 41) 9

10 42) Which one of the following statements is the most accurate? A) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply. B) Under a dirty float exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply or its output. C) Under a fixed exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply or its output. D) Under a flexible exchange rate, central bank monetary tools are powerless to affect the economyʹs money supply or its output. E) Under a fixed exchange rate, fiscal policy tools are powerless to affect the economyʹs money supply or its output. 42) 43) Which one of the following statements is the most accurate? A) Revaluation reflects a deliberate government decision while appreciation is an outcome of government actions and market forces acting together. B) Revaluation and appreciation have the same meaning and the same causes. C) Revaluation reflects an outcome of government actions and market forces acting together while appreciation reflects a deliberate government decision. D) Revaluation reflects a deliberate government decision while appreciation is an outcome of government actions. 43) 44) How does an increase in the real exchange rate affect exports and imports? A) Exports change ambiguously; imports decrease. B) Exports increase; imports decrease. C) Exports increase; imports are constant. D) Exports decrease; imports increase. E) Exports increase; imports change ambiguously. 44) 45) Assume the economy is initially consuming along the inter-temporal budget constraint at point A, where no saving occurs. How does a fall in the real interest rate (r) affect present consumption? 45) A) Present consumption is unaffected. B) Present consumption decreases. C) Present consumption increases. D) Present consumptionʹs change is ambiguous. E) Not enough information is provided. 10

11 46) Real exchange rate, q, is best described by A) The price of the foreign basket in terms of the domestic basket. B) The price of similar goods in the same market. C) The price of different goods baskets in the same market. D) The price of the domestic basket in terms of the foreign one. E) The price of a domestic basket. 46) 47) In the long-run equilibrium, after a permanent money-supply increase there follows: A) A decrease in output, Y B) A decrease in exchange rate, E C) An increase in exchange rate, E D) An increase in output, Y E) Both B and D. 47) 48) How does a rise in real income affect aggregate demand? A) Y Yd Im CA AD, and Y Yd C AD B) Y Yd Im CA AD, but Y Yd C AD by less C) Y Yd Im CA AD, but Y Yd C AD by more D) Y Yd Im CA AD, but Y Yd C AD by more E) Y Yd Im CA AD, but Y Yd C AD by less 48) 49) The J-curve illustrates which of the following? A) The immediate increase in current account caused by a currency depreciation B) The short-term effects of depreciation on the current account C) The Keynesian view of international trade dynamics D) The effects of depreciation on the home countryʹs economy E) The gradual adjustment of home prices to a currency depreciation 49) 50) Which of the following would not cause the real exchange rate to fall? A) A rise in the exchange rate, E. B) Depreciation of the home currency. C) A fall in foreign prices, P. D) A rise in domestic prices, P. E) A right shift of the aggregate demand curve. 50) 11

12 51) A system of managed floating exchange rates is A) A system in which governments are forbidden from attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. B) A system in which governments use flexible exchange rates. C) A system in which governments need to reach a prior agreement among them before they may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. D) A system in which governments may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. E) None of the above statement is true. 51) 52) The main reason(s) why governments sometimes chose to devalue their currencies is (are): A) Devaluation improves in the current account. B) Devaluation allows the government to fight domestic unemployment despite the lack of effective monetary policy. C) Devaluation increases foreign reserves held by the central bank. D) All of the above. 52) 53) Imperfect asset substitutability exists A) when the expected returns on two assets are the same B) when it is possible for the expected returns on two assets to be different C) only when one asset is foreign and the other is domestic D) when there is risk in the foreign exchange market E) A and D. 53) 54) Under fixed exchange rate, which one of the following statements is the most accurate? A) Devaluation causes a reduction in output. B) Devaluation causes a reduction in official reserves. C) Devaluation has no effect on the stock of money. D) Devaluation causes a reduction of the money supply. E) Devaluation causes an expansion of the money supply. 54) 55) In the short-run, a temporary increase in fiscal policy causes A) A shift of the DD curve to the left, output increases and the currency appreciates B) A shift of the DD curve to the right, output increases and the currency depreciates C) A shift of the DD curve to the right, output decreases and the currency appreciates D) A shift of the DD curve to the right, output increases and the currency appreciates E) A shift of the DD curve to the left, output decreases and the currency depreciates 55) 12

13 56) Which one of the following statements is the most accurate? A) An increase in the real exchange rate and an increase in disposable income improve the current account. B) An increase in the real exchange rate and a decrease in disposable income improve the current account. C) A decrease in the real exchange rate and a decrease in disposable income improve the current account. D) A decrease in the real exchange rate and a increase in disposable income improve the current account. 56) 57) During the Great depression of the 1930s, A) The nominal interest rate hit 2 percent in the United States. B) The real interest rate hit 2 percent in the United States. C) The nominal interest rate hit one percent in the United States. D) The nominal interest rate hit zero in the United States. E) The real interest rate hit zero in the United States. 57) 58) The current account increases when: A) Domestic prices fall. B) Real exchange rate decreases. C) Disposable income increases. D) Exports fall. E) Real exchange rate increases. 58) SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 59) Fill in the following table: 59) E P P EP /P

14 60) Using a figure show that under full employment, a temporary fiscal expansion would increase output (over-employment) but cannot increase output in the long run. 60) 61) Find the real exchange rate for the following case: Assume that the representative basket of European goods costs 100 euros and the representative U.S. basket costs $125, and the dollar/euro exchange rate is $0.75 per euro, then the price of the European basket in terms of U.S. basket is: 61) 62) Using a figure, show how devaluation affects an economy. 62) 63) Find the real exchange rate for the following case: Assume that the representative basket of European goods and services costs 40 euros and the representative U.S. basket costs $50, and the dollar/euro exchange rate is $0.90 per euro, then the price of the European basket in terms of U.S. basket is. 63) 64) Assume an economy is in a liquidity trap. (a) Write an equation expressing interest rate parity under a fixed exchange rate regime. (b) Assume Ee is fixed. Suppose that the central bank raises the domestic money supply so as to depreciate the currency temporarily (that is, to raise E currently but return the rate to Ee later). Show that E cannot be raised. 64) ESSAY. Write your answer in the space provided or on a separate sheet of paper. 65) Explain what are the factors that shift the AA Schedule? 66) Explain how does an increase in the real exchange rate affect exports and imports? 67) What is the AA-curve? Why does it have a negative slope? What factors cause it to shift? 68) Explain how does a rise in real income affect aggregate demand 69) Give 4 examples of situations that would cause the DD-curve to shift to the left. 70) Explain the problems experienced by Brazil in the post-1994 period as a result of the real appreciation of its currency, the Real, and how these problems led to an eventual devaluation. 71) What are the three main reasons why governments sometimes chose to devalue their currencies? 72) Discuss the main factors affecting the position of the DD schedule. 73) Why Study Fixed Exchange Rates? 74) What is the real exchange rate? What is its relationship to the current account? 14

15 Answer Key Testname: HOMEWORK ) D 2) A 3) A 4) E 5) A 6) E 7) D 8) E 9) E 10) D 11) A 12) A 13) C 14) D 15) A 16) A 17) E 18) D 19) A 20) D 21) D 22) A 23) B 24) B 25) E 26) C 27) B 28) C 29) C 30) D 31) C 32) D 33) D 34) C 35) D 36) E 37) D 38) B 39) E 40) D 41) B 42) C 43) A 44) E 45) C 46) A 47) C 48) D 49) B 50) E 15

16 Answer Key Testname: HOMEWORK ) D 52) D 53) D 54) E 55) D 56) B 57) D 58) E 59) E P P EP /P ) A temporarily fiscal expansion will move the economy from DD1 to DD2, and output increases. A permanent fiscal expansion will also shift the AA curve to the left and down. The nominal exchange rate appreciates, i.e. E decreases. 61) [(0.75 $/euro) (100 euro per a European basket)]/[(125 $/U.S. basket)] 0.60 US baskets/european basket. 16

17 Answer Key Testname: HOMEWORK ) When a currency is devalued from E0 to E1, the equilibrium shifts from point 1 to 2. Both output and money supply increase. 63) [(0.9 $/euro) (40 euro per a European basket)]/[(50 $/U.S. basket)] 64) (a) Liquidity trap implies R = 0. R = 0 = R + (Ee - E)/E (b) Since R = 0, the equation in part A, the interest parity condition, implies: E = Ee/(1 - R ). Since Ee and R are fixed, E cannot change. 65) Changes in the domestic money supply; changes in the domestic price level; changes in the expected future exchange rates; changes in the foreign interest rate and shifts in the aggregate real money demand. 66) When the real exchange rate increases, domestic products are cheaper relative to foreign products. Due to this, exports increase as foreigners demand more of our exports. The change in imports is ambiguous because fewer units of imports are purchased (the volume effect), but each foreign unit is now more expensive (the value effect). Remember: exports and imports are measured in terms of domestic output, i.e. dollar value, not volume of units. However, we often assume that the volume effect outweighs the value effect, so that imports decrease when the real exchange rate rises. 67) The AA-curve is the specific levels of E and Y under which the money and foreign exchange markets are in equilibrium. The AA-curve has a negative slope because an increase in Y will cause E to fall (a domestic currency appreciation). The factors that affect it are: the money supply, price level, expected exchange rate, foreign interest rates, and the level of real money demand. 68) A rise in domestic real income, Y, leads to a rise in disposable income, Yd. This raises the spending on imports, IM, thus lowering the current account, CA, and reducing aggregate demand, AD. However, the rise in Yd also causes a rise in consumption, C, and raises aggregate demand, AD, by more than the corresponding decrease. 69) Correct answers include any situations that involve: (1) an decrease in government spending (eg. Decrease in military spending) (2) an increase in taxes. (3) a fall in Investment demand (4) a price increase, which would lower net export demand (assuming E and P stay constant) (5) a fall in foreign prices (assuming E and P stay constant) (6) an autonomous fall in consumption demand (as long as it is not entirely a change in import demand) (7) a shift to demanding more foreign goods at the expense of domestic good demand 17

18 Answer Key Testname: HOMEWORK ) When the Real appreciated, so did Brazilʹs real exchange rate, thus lowering the economyʹs competitiveness in foreign markets. In an effort to maintain capital inflows into the country, and to defend the real against depreciation, Brazil was forced to adopt very high domestic interest rates, which in turn increased the difficulties in repaying its public debt, and led to a rise in the governmentʹs fiscal deficit. As banks failed and unemployment spread, foreigners began to anticipate a collapse of the Brazilian economy, and the IMF stepped in with a stabilization fund of $40.5 billion to prevent Brazil from devaluing. The aid, however, did not help, and Brazil devalued the Real by 8 percent in January of 1999, and allowed it float and lose a further 40 percent of its value. 71) 1. Allow the government to fight domestic unemployment despite the lack of effective monetary policy. 2. Improve in the current account. 3. Increase foreign reserves held by the central bank. 72) The level of government demand, taxes, and investment; the domestic and foreign price levels; variations in domestic consumption behavior; and the foreign demand for home output. 73) Four main reasons: Managed Floating-Present monetary system is hybrid of pure fixed and floating rate systems; fixed exchange rates give insight to effects of foreign exchange intervention under floating rates. Regional Currency Arrangements-Exchange rate unions exist where member nations fix mutual exchange rates. Developing Countries and Countries in Transition-Nearly half the world engages in currency pegging. Lessons of Past-Fixed exchange rates were the norm in many historical periods; many economists propose resurrection of some fixed rate system. 74) Defined as: EP /P (the exchange rate multiplied by foreign prices, divided by domestic prices). While the nominal exchange rate measures how much of a foreign currency one can buy with a unit of domestic currency, the real exchange rate measures how many goods and services one could buy. A rise in the real exchange rate (a depreciation of domestic currency) means that domestic goods are cheaper compared to foreign goods, so exports increase and imports decrease. Aggregate demand increases and the CA rises. A fall in the real exchange rate has the opposite effect: Aggregate demand decreases and the CA falls. 18

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