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MIT 14 02 - Problem Set 6

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14.02 Fall 2001Problem Set 6Posted October 24, 2001Due October 31, 2001I. True/False (explain) (30 points, 5 each)1. Your wealthy grandmother has all her wealth invested in US government bonds. Ona recent trip to the Carnival in Rio de Janeiro, your grandmother returns andenthusiastically describes to you how the interest rate on Brasilian bonds is so muchmore desirable in comparison to the low interest she gets on her US bonds, and that asa result she will invest her wealth in Brasilian bonds instead. Is your grandmother’sreasoning true or false? and what do you tell her? (Assume you care for yourgrandmother whether out of altruism or because you stand to inherit her fortune.)2. The finance minister in Trustlesstan is fed up with the high interest payments hisgovernment has to pay on its debt. He cleverly decides to issue government debtdenominated in US dollars instead. To his great surprise, the interest rate on this newdebt still exceeds the interest rate on similar maturity US government debt. True orfalse: He should ask for his money back from Olivier Blanchard, the author of his 14.02book.3. In a last ditch attempt to keep his job, our friend the finance minister of Trustlesstan,is persuaded by Blanchard not to prosecute and even to order a newer snazzier editionof his textbook. Blanchard then advises him to devalue the currency in order toincrease demand for domestic goods and improve the trade balance as a result. Ourhapless finance minister is fired from his job a week after devaluing the currencybecause net exports fall as a result. He is replaced by another finance minister who iscredited for increasing net exports in later months because of his patriotic speeches.True or false: the new minister is certainly effective.4. There are two countries: Harvard and MIT and the unit of exchange in each country isthe GPA of the respective country. Suppose initially that the two countries initially fixtheir exchange rate at one-to-one. Your current GPA is very low. A friend recommendsyou take 14.02 to boost your GPA for sure. But you have the choice between taking14.02 at MIT or a similar course at Harvard. (charisma of TA does not enter yourdecision). If you invest one hour a week in 14.02 at MIT (a realistic assumption) thereturn is a GPA increase of 1 point, while at Harvard you would get 3 points. True orfalse: if the registrars maintain the fixed exchange rate at one-to-one, the MIT class will1be deserted. How can the situation be improved? (Assume your TA actually enjoysteaching.)5. You are deciding whether to move to Ukraine or to stay in the US. You decide tocalculate the relative price of goods between the 2 countries (only the real exchangerate enters your consideration of which country to live in). You look up the exchangerate and find that it is 0.2 US$ per one Hryvnia. You then look up the GDP deflators ofthe two countries and find that the GDP deflator in Ukraine was 50 while for the US itwas 100. True or false: you conclude that it is 10 times more expensive in the US thanin Ukraine, so you move there.6. Suppose Md/P YL i , but prices are fixed in the short run. Suppose there is anexpansionary monetary policy today. Also assume to be true that money is ’neutral’ inthe long run (that is M/M P/P E/E in the long run). In the short run, the increasein money supply leads the exchange rate to depreciate but less than the long run value.II. Small versus Large Economy (30 points)Suppose there are two types of countries in the world, small and large. The behavioralequations for the small country are:C YI Y iG given (exogenous)NX Y Ys1E, where the superscript ”s” denotes small, and have assumed thatprices are fixed so e E.There are similar behavioral equations for the large country:s l.1. (5 points) What does our theory tell us about the relation between E (defined as inclass and book) and net exports?2. Now suppose Et 1e_E 1. Also suppose that the world interest rate is described by:i 1 as_i asi,where_i is dependent on economic conditions in rest of world andasis the weight of the domestic interest rate for the small country.(i) (6 pts) Use the arbitrage condition from trading domestic versus foreign assets andderive E(i). Plot with E on the y-axis.(ii) (4 pts) Plot on the same graph the relation for a large country, that is alas.Interpret the different slopes. Where do the two curves intersect?3. (5 pts) Now solve for the goods market equilibrium in each country. What is the slopeof the IS with i on the y-axis. Plot the two curves for a small and large countryrespectively (lversuss). How do they compare?24. (5 pts) Now include a standard LM curve in the (i,Y) space. Analyze the effect of amonetary expansion in the two countries. In which country is monetary expansion moreeffective with respect to altering Y?5. (5 pts) Now analyze the effects of a fiscal expansion in either country. Where is fiscalpolicy more effective?III. Non-standard IS (20 points)Recall that the standard IS relation is (holding prices fixed):Y C Y T I Y,i G NX Y,Y ,ENow assume that T 0 (for simplicity) and that there are two types ofconsumers: workers and profit earners (employers). Workers’ consumption function isC1WYE. That is, consumption is still a function of ”real” income, but it is morecomplicated than just Y. Workers in this economy earn a wage W for the value of theirreal output, Y (their nominal income is WY). They then consume goods whose price is E(or some P E . To get a kick out of this model, we need to assume that profitearners (employers) have a different consumption behavior. For example theirconsumption C2YWYEfalls entirely on imports. Continue to assume that NX respondpositively to exchange rate depreciations (for example the exports of this country are notconsumed at home and so a nominal depreciation affects the relative price of thiscountry’s exports).1. (5 pts) Why might we want to model consumption as a function of WY/E rather thanjust Y?2. (5 pts) Graph the standard IS curve and the new IS curve in the (i,Y) space. Assumethat the other components of demand are unchanged. How do the two curves compare?Continue to assume that the IS is downward sloping.3. (5 pts) Is monetary policy more or less effective than in the standard case? Why?4. (5 pts) Now suppose workers gain bargaining power through newly establishedstrong labor unions after a period of large devaluations drove people to the street inriots. These labor unions decide to index the wage to the


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MIT 14 02 - Problem Set 6

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