PS 4 Solution Econ 201

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1 PS 4 Solution Econ 201 Chapter 19: 3. If Congress passes an investment tax credit, it subsidizes domestic investment. The desire to increase domestic investment leads firms to borrow more, increasing the demand for loanable funds, as shown in Figure 5. This raises the real interest rate, thus reducing net capital outflow. The decline in net capital outflow reduces the supply of dollars in the market for foreign exchange, raising the real exchange rate. The trade balance also moves toward deficit, because net capital outflow, hence net exports, is lower. The higher real interest rate also increases the quantity of national saving. In summary, saving increases, domestic investment increases, net capital outflow declines, the real interest rate increases, the real exchange rate increases, and the trade balance moves toward deficit. Exporters will oppose this policy because the appreciation of the real exchange rate will cause exports to fall and imports to rise as the trade balance falls.

2 4. a. A decline in the quality of U.S. goods at a given real exchange rate would reduce net exports, reducing the demand for dollars, thus shifting the demand curve for dollars to the left in the market for foreign exchange, as shown in Figure 6. b. The shift to the left of the demand curve for dollars leads to a decline in the real exchange rate. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. c. The claim in the popular press is incorrect. A change in the quality of U.S. goods cannot lead to a rise in the trade deficit. The decline in the real exchange rate means that we get fewer foreign goods in exchange for our goods, so our standard of living may decline.

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4 5. A reduction in restrictions of imports would reduce net exports at any given real exchange rate, thus shifting the demand curve for dollars to the left. The shift of the demand curve for dollars leads to a decline in the real exchange rate, which increases net exports. Because net capital outflow is unchanged, and net exports equals net capital outflow, there is no change in equilibrium in net exports or the trade balance. But both imports and exports rise, so export industries benefit. 6. a. When the French develop a strong taste for California wines, the demand for dollars in the foreign-currency market increases at any given real exchange rate, as shown in Figure 7. b. The result of the increased demand for dollars is a rise in the real exchange rate. c. The quantity of net exports is unchanged.

5 7. An export subsidy increases net exports at any given real exchange rate. This causes the demand for dollars to shift to the right in the market for foreign exchange, as shown in Figure 8. The effect is a higher real exchange rate, but no change in net exports. So the senator is wrong; an export subsidy will not reduce the trade deficit.

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7 8. Higher real interest rates in Europe lead to increased U.S. net capital outflow. Higher net capital outflow leads to higher net exports, because in equilibrium net exports equal net capital outflow (NX = NCO ). Figure 9 shows that the increase in net capital outflow leads to a lower real exchange rate, higher real interest rate, and increased net exports.

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9 Chapter Figure 8 shows two different short-run Phillips curves depicting these four points. Points A and D are on SRPC1 because both have expected inflation of 3%. Points B and C are on SRPC2 because both have expected inflation of 5%. 2. a. A rise in the natural rate of unemployment shifts the long-run Phillips curve to the right and the short-run Phillips curve up, as shown in Figure 9. The economy is initially on LRPC1 and SRPC1 at an inflation rate of 3%, which is also the expected rate of inflation. The increase in the natural rate of unemployment shifts the long-run Phillips curve to LRPC2 and the short-run Phillips curve to SRPC2, with the expected rate of inflation remaining equal to 3%.

10 b. A decline in the price of imported oil shifts the short-run Phillips curve down, as shown in Figure 10, from SRPC1 to SRPC2. For any given unemployment rate, the inflation rate is lower, because oil is such a significant aspect of production costs in the economy.

11 c. A rise in government spending represents an increase in aggregate demand, so it moves the economy along the short-run Phillips curve, as shown in Figure 11. The economy 438 Chapter 22/The Short-Run Trade-off between Inflation and Unemployment moves from point A to point B, with a decline in the unemployment rate and an increase in the inflation rate. d. A decline in expected inflation causes the short-run Phillips curve to shift down, as shown in Figure 12. The lower rate of expected inflation shifts the short-run Phillips curve from SRPC1 to SRPC2.

12 3. a. Figure 13 shows how a reduction in consumer spending causes a recession in both an aggregate-supply/aggregate-demand diagram and a Phillips-curve diagram. In both diagrams, the economy begins at full employment at point A. The decline in consumer spending reduces aggregate demand, shifting the aggregate-demand curve to the left from AD1 to AD2. The economy initially remains on the short-run aggregate-supply curve SRAS1, so the new equilibrium occurs at point B. The movement of the aggregatedemand curve along the short-run aggregate-supply curve leads to a movement along short-run Phillips curve SRPC1, from point A to point B. The lower price level in the aggregate-supply/aggregate-demand diagram corresponds to the lower inflation rate in the Phillips-curve diagram. The lower level of output in the aggregate-supply/aggregatedemand diagram corresponds to the higher unemployment rate in the Phillips-curve diagram.

13 b. As expected inflation falls over time, the short-run aggregate-supply curve shifts down from AS1 to AS2, and the short-run Phillips curve shifts down from SRPC1 to SRPC2. In both diagrams, the economy eventually gets to point C, which is back on the long-run aggregate-supply curve and long-run Phillips curve. After the recession is over, the economy faces a better set of inflation-unemployment combinations. 4. a. Figure 14 shows the economy in long-run equilibrium at point A, which is on both the long-run and short-run Phillips curves.

14 b. A wave of business pessimism reduces aggregate demand, moving the economy to point B in the figure. The unemployment rate rises and the inflation rate declines. If the Fed undertakes expansionary monetary policy, it can increase aggregate demand, offsetting the pessimism and returning the economy to point A, with the initial inflation rate and unemployment rate. c. Figure 15 shows the effects on the economy if the price of imported oil rises. The higher price of imported oil shifts the short-run Phillips curve up from SRPC 1 to SRPC 2. The economy moves from point A to point C, with a higher inflation rate and higher unemployment rate. If the Fed engages in expansionary monetary policy, it can return the economy to its original unemployment rate at point D, but the inflation rate will be higher. If the Fed engages in contractionary monetary policy, it can return the economy to its original inflation rate at point E, but the unemployment rate will be higher. This situation differs from that in part (b) because in part (b) the economy stayed on the same short-run Phillips curve, but in part (c) the economy moved to a higher short-run Phillips curve, which gives policymakers a less favorable trade-off between inflation and unemployment.

15 5. Economists who believe that expectations adjust quickly in response to changes in policy would be more likely to favor using contractionary policy to reduce inflation than economists with the opposite views. If expectations adjust quickly, the costs of reducing inflation (in terms of lost output) will be relatively small. Thus, Milton would be more in favor of following a policy to reduce inflation than would James.

16 6. If the Fed acts on its belief that the natural rate of unemployment is 4%, when the natural rate is in fact 5%, the result will be a spiraling up of the inflation rate, as shown in Figure 16. Starting from a point on the long-run Phillips curve, with an unemployment rate of 5%, the Fed will believe that the economy is in a recession, because the unemployment rate is greater than its estimate of the natural rate. Therefore, the Fed will increase the money supply, moving the economy along the short-run Phillips curve SRPC1. The inflation rate will rise and the unemployment rate will fall to 4%. As the inflation rate rises over time, expectations of inflation will rise, and the short-run Phillips curve will shift up to SRPC2. This process will continue, and the inflation rate will spiral upwards. The Fed may eventually realize that its estimate of the natural rate of unemployment is wrong by examining the rising trend in the inflation rate. 3. Chapter 18: 1, 2, 5, 9, 10, a. When an American art professor spends the summer touring museums in Europe, he spends money buying foreign goods and services, so U.S. exports are unchanged, imports increase, and net exports decrease. b. When students in Paris flock to see the latest movie from Hollywood, foreigners are buying a U.S. good, so U.S. exports rise, imports are unchanged, and net exports increase.

17 c. When your uncle buys a new Volvo, an American is buying a foreign good, so U.S. exports are unchanged, imports rise, and net exports decline. d. When the student bookstore at Oxford University sells a pair of Levi's 501 jeans, foreigners are buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. e. When a Canadian citizen shops in northern Vermont to avoid Canadian sales taxes, a foreigner is buying U.S. goods, so U.S. exports increase, imports are unchanged, and net exports increase. 2. a. When an American buys a Sony Walkman, there is a decrease in net exports. b. When an American buys a share of Sony stock, there is an increase in net capital outflow. c. When the Sony pension fund buys a U.S. Treasury bond, there is a decrease in net capital outflow. d. When a worker at Sony buys some Georgia peaches from an American farmer, there is an increase in net exports. 5. a. When an American cellular phone company establishes an office in the Czech Republic, U.S. net capital outflow increases, because the U.S. company makes a direct investment in capital in the foreign country. b. When Harrod's of London sells stock to the General Electric pension fund, U.S. net capital outflow increases, because the U.S. company makes a portfolio investment in the foreign country. c. When Honda expands its factory in Marysville, Ohio, U.S. net capital outflow declines, because the foreign company makes a direct investment in capital in the United States. d. When a Fidelity mutual fund sells its Volkswagen stock to a French investor, U.S. net capital outflow declines (if the French investor pays in U.S. dollars), because the U.S. company is reducing its portfolio investment in a foreign country. 9. All the parts of this question can be answered by keeping in mind the definition of the real exchange rate. The real exchange rate equals the nominal exchange rate times the domestic price level divided by the foreign price level. a. If the U.S. nominal exchange rate is unchanged, but prices rise faster in the United States than abroad, the real exchange rate rises. b. If the U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in the United States, the real exchange rate declines. c. If the U.S. nominal exchange rate declines and prices are unchanged in the United States and abroad, the real exchange rate declines. d. If the U.S. nominal exchange rate declines and prices rise faster abroad than in the United States, the real exchange rate declines.

18 10. If purchasing-power parity holds, then 12 pesos per soda divided by $0.75 per soda equals the exchange rate of 16 pesos per dollar. If prices in Mexico doubled, the exchange rate will double to 32 pesos per dollar. 11. a. To make a profit, you would want to buy rice where it is cheap and sell it where it is expensive. Because American rice costs 100 dollars per bushel, and the exchange rate is 80 yen per dollar, American rice costs 100 x 80 equals 8,000 yen per bushel. So American rice at 8,000 yen per bushel is cheaper than Japanese rice at 16,000 yen per bushel. So you could take 8,000 yen, exchange them for 100 dollars, buy a bushel of American rice, then sell it in Japan for 16,000 yen, making a profit of 8,000 yen. As people did this, the demand for American rice would rise, increasing the price in America,and the supply of Japanese rice would rise, reducing the price in Japan. The process would continue until the prices in the two countries were the same. b. If rice were the only commodity in the world, the real exchange rate between the United States and Japan would start out too low, then rise as people bought rice in America and sold it in Japan, until the real exchange became one in long-run equilibrium.

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