Economics 3422 Sample Final Examination

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1 Economics 3422 Sample Final Examination Instructions: Put your name and PeopleSoft ID on the blue book provided. Put all your answers in the blue book provided. Turn both question sheet and blue book in at the end of the examination. Part A is 25 points, Part B is 15 points, and part C is 30 points. The total is 70 points. Part A: Multiple Choice. Choose the best alternative that answer or completes the sentence. 1. Balance of Payments equilibrium means a. the balance of trade equals zero b. the current account balance equals zero c. the capital account balance equals zero d. the current account balance is exactly offset by the capital account balance 2. Macroeconomic equilibrium in an open economy requires a. goods market equilibrium b. money market equilibrium c. balance of payments equilibrium d. all of the above e. only (a) and (b) above 3. An implication of the asset approach is that a. since financial asset prices change rapidly, exchange rate should vary more than goods prices b. since PPP holds even in the short-run, goods prices should change as rapidly as the exchange rate c. covered interest parity will rarely hold if there is perfect capital mobility d. goods prices will be largely unaffected by exchange rate changes in the long run 4. Suppose the U.S. fixes the price of gold at $2.00 per ounce, and Germany fixes the price of gold at 4.00 per ounce. The $/ exchange rate is a. 1:2 b. 2:1 c. 1:1 d. 1:4 5. The elasticity approach to the balance of trade a. focuses on the effects of changing relative prices of domestic and foreign goods on the balance of trade b. is only applicable with a floating exchange rate system c. is based on an analysis of the absolute prices of a country s exports in world markets d. indicates that the demand elasticity for exports is always inelastic 6. The J-curve a. only occurs under fixed exchange rates b. occurs when a currency is appreciated c. shows the initial worsening of the balance of trade with a devaluation d. shows how the balance of trade immediately improves after a devaluation 7. The monetary approach to the balance of payments a. focuses on the importance of the current account balance b. views exchange rate variations as the sole adjustment mechanism c. highlights the role of financial assets of payments adjustment d. implies that the price level and exchange rate can both be determined by the central bank

2 8. Under the flexible exchange rate, an increase in the foreign price level that leads to a domestic currency appreciation is an example of a. interest rate parity b. purchasing power parity c. insulating property of the flexible exchange rate d. both (a) and (b) e. both (b) and (c) 9. An expansionary monetary policy under flexible exchange rates will lead to of the home currency and thus will be effective in increasing national income than under fixed exchange rates. a. an appreciation; more b. a depreciation; more c. an appreciation; less d. a depreciation; less 10. Under flexible exchange rate and perfect capital mobility, an expansionary fiscal policy will lead to an incipient BOP, and the will shift to the to restore equilibrium. a. deficit; IS; left b. surplus; IS; left c. deficit; LM; right d. surplus; BP; left 11. Fiscal policy is the least effective in changing national income under flexible exchange rates when capital is a. perfectly immobile b. imperfectly mobile with BP curve steeper than LM curve c. perfectly mobile d. imperfectly mobile with LM curve steeper than BP curve 12. Under the Portfolio Balance Approach, an increase in domestic income, everything equal, will the demand for money, the demand for domestic bond, and the demand for foreign bond. a. increase; increase; increase b. increase; decrease; decrease c. increase; decrease; no change d. decrease; increase; increase 13. Under fixed exchange rates, a BOP surplus will lead to a in the money supply as the central bank in order to maintain the fixed exchange rate. a. rise; purchases domestic currency b. fall; sells domestic currency c. rise; purchases foreign currency d. fall; sells foreign currency 14. In the Mundell-Fleming model under fixed exchange rates, the automatic adjustment process produces BOP equilibrium as a. the LM curve shifts along the fixed IS and BP curves b. the IS curve shifts along the fixed LM and BP curves c. the BP curve shifts along the fixed IS and LM curves d. the IS, LM, and BP curves all shift 15. A policy that is effective in changing national income, and is available only under fixed exchange rates and not flexible exchange rates is a. monetary policy b. a policy of devaluation/revaluation c. fiscal policy d. an exchange rate policy

3 16. The autonomous spending multiplier is larger, the larger the, and the smaller the and the. a. marginal tax rate; MPC; MPM b. MPM; MPC; marginal tax rate c. MPC; marginal tax rate; MPM d. MPS; MPC; MPM 17. The main difference between the monetary approach and the portfolio balance approach is that: a. the monetary approach allows the holding of both domestic and foreign currencies b. the monetary approach allows the holding of both domestic and foreign bonds c. the portfolio balance approach allows the holding of both domestic and foreign currencies d. the portfolio balance approach allows the holding of both domestic and foreign bonds 18. In the two-country model of the monetary approach to exchange rate determination, a domestic currency appreciation may be caused by a. an increase in domestic country s money supply b. a decrease in domestic country s income c. a decrease in foreign country s income d. an increase in foreign country s money supply 19. Under flexible exchange rates, a depreciation of the home currency will shift the curves to the. a. IS and LM; right b. IS and LM; left c. IS and BP; right d. IS and BP; left 20. The Marshall-Lerner condition ensures that a. the money market is stable b. the goods market is stable c. a depreciation of the home currency will improve home country s current account d. an appreciation of the home currency will improve home country s current account Answer questions with reference to the Mundell-Fleming model below. 21. The Mundell-Fleming model is a model of a. a large open economy b. a small open economy c. a small open economy in the short-run d. a small open economy in the long-run e. a large open economy in the short-run 22. Starting from the initial equilibrium, suppose there is an expansionary fiscal policy; a. LM curve shifts to the right to a point such as 2 b. LM curve shifts to the left to a point such as 1 c. IS curve shifts to the right to a point such as c d. IS curve shifts to the left to a point such as a e. None of the above 23. At the temporary equilibrium, there is a temporary balance of payment: a. surplus b. deficit c. it is in balance d. none of the above

4 24. In the foreign exchange market, the domestic currency is under pressure to: a. remain the same b. depreciate/devaluate c. appreciate/revaluate d. none of the above 25. Suppose this is a flexible exchange-rate economy, in order to restore equilibrium a. LM curve must shift back to its original position b. both the IS and BP curves must shift to the left c. both the IS and BP curves must shift to the right d. both the IS and LM curves must shift to the left e. both the IS and LM curves must shift to the right i LM BP 1 c II b I a 2 IS Y Part B: Definitions, short explanations. (5 points each, the total is 15 points) 1. Define or give short explanations to each of the following: a. Monetary and fiscal policy co-ordination b. The insulating property of a flexible exchange rate c. Unstable market 2. Given C = Yd ; T = Y; I = 230; G = 560; X = 350; M = Y a. What is the slope of the expenditure function? b. What is the autonomous spending multiplier? 3. Suppose U.S. produces and sells USgood at $3.00 a unit, Germany produces and sells Eurogood at 2.00 a unit. Suppose at US$/ = $1.50, U.S demands 200 units of Eurogood and sells 150 units of USgood to Germany. Assume that U.S. and Germany only trade with each other. Does the U.S. have a current account deficit or surplus and how much?

5 Part C: Essay. Question 1 is 20 points, and question 2 is 10 points. 1. Suppose Country A is a small-open economy with imperfect capital mobility operating under flexible exchange rates. a. Draw and completely label a Mundell-Fleming diagram for this economy and identify the initial equilibrium and mark it with an a. b. Suppose now the Central Bank of Country A expands its money supply, identify the temporary equilibrium and make it with a b. c. At the temporary equilibrium, how do interest rate and real income compared to the initial equilibrium? Provide economic explanations for these changes. d. At the temporary equilibrium, is there a temporary BOP deficit or surplus? Provide economic explanation for this result (i.e., it is not enough to say that the temporary equilibrium is to the left or the right of the BP curve). e. Describe carefully (i.e., explain how and why) how Country A would arrive at a new equilibrium and mark it c. 2. Carefully explain the pros and cons of a fixed exchange rate system. Solution: Part A: 1. D; 2. D; 3. A; 4. A; 5. A; 6. C; 7. C; 8. E; 9. B; 10. B; 11. C; 12. A; 13. C; 14. A; 15. B; 16. C; 17. D; 18. C (or D); 19. C; 20. C; 21. C; 22. C; 23. A; 24. C; 25. B Part B: 1. a. Under a flexible exchange rate system, monetary policy is not restricted to maintaining a fixed exchange rate and thus can be used to attain an internal (domestic) objective. If used in co-ordination with fiscal policy, two internal objectives, such as a target interest rate and a target real output level, can be attained simultaneously. b. Under a flexible exchange rate system, movements in the exchange rate can insulate the domestic economy from a foreign monetary shock so that the domestic economy is not affected. For example, suppose there is foreign inflation. In this case, domestic currency would appreciate against the foreign currency, leaving the real exchange rate unchanged. In this case, domestic real output will be unaffected. c. A market is unstable if an excess demand leads to an increase in price but away from an equilibrium and not toward an equilibrium. Put differently, an unstable market is one where if it departs from an equilibrium can never return to the equilibrium. 2. a. The slope of the expenditure function is[0.75(1 0.2) 0.10] 0.5. b. The autonomous spending multiplier is 1 1 k 2. 1 slope of expenditure function We will have to first find U.S. imports and exports in U.S. $. U.S. imports: 200x 2.00x$1.50/ = $600 U.S. exports: 150x$3.00 = $450 U.S. current account = $450 - $600 = -$150 (deficit)

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