Problem Set 4 Answ ers14.02 Fall 20011 Tru e or fals e, explain1. False. An expensiv e dollar m akes American industries less com-petitive. For tourists however this could be true.2. False. If the y en becomes weaker and prices of japanes cars arefixed, cars will be cheaper. If there is sufficien t car inflation inJapan, ho w ever, it could be agood idea to an ticipate buying aJapanese car.3. Depends. If the Colombians deb t is denom ina ted in dollars it istrue. If his debt is denominated in pesos it is false because thedebt has lost value when conver ted into dollars.4. False. We expect the European in ter est rate to be higher now andthe same after the depreciation occurs.5. False. Both coun tries ha ve the same currency, in terest rate parityequation cannot explain the difference if there is any.6. True. If people expect a devaluation, when it happens in terestrates must fall according to th e U IP e quation and investment reactspositively to low er inter est rates.7. True. If Chile generates expectations of devalu ation of its currency,interest rates m ust rise and the deman d for money will fall.8. False. Dollar bills are US issued assets, if the exporter gets payedin dollars, the rest of the world is holding less US assets and thereis an increase in net foreign holdings of US assets.19. False. Neither of these transactions ch an ge the net foreign holdingsof US assets.10. False, if there are different currencies, the UIP equation tells usthat in ter est rates can be different from country to country.2 Monetary Questions1. The reserv e ratio requiremen t is not binding at very low lev els ofthe in terest rate. If i increases, banks may be willing to take morerisks by lo wering the reserves that they hold and using those fundsto give credit. A t high levels of the in terest rate, banks would hav ea strong incen tive to reduce their reserv es ev en further to v ery lo wlev els, but then the reserv e ratio requirement becomes binding.2. If checking accoun ts pay an inter est rate they will make it lessattractiv e to hold pock et money when in terest rates go up. IfY goes up but transaction requirem ents have a limit or grow atslo wer rates, then c will depend on Y .3. Wh en in terest rates go up. H ouseh olds deposit more money intheir chec king accounts. This gives the banking system resourcesto create more money. Banks lo wer the reserv e ratio creating ev enmore money. The m ultiplier increases.4. Equilibrium in the high po wered money market isH = PYL(i)n1 − (1 − θ − θ + φi)(1 − c + ci)oequilibrium in the money mark et isH1 − (1 − θ − θ + φi)(1 − c + ci)= PYL(i)when i ≤θφ.5. More effective. If the multiplier increases with the in terest rate,money supply increases with the interest rate. This means thatinterest rates will not climb so high when money demand is pushedto expand b y higher nomin al income. Hence, the LM is more elasticand fisca l policy is more effective.6. Same as 5.27. A positive h means that when income pushes money demand up,mone y supply is in fact contracting. This will ma ke interest ratesrise more for a giv en expansion in incom e. The LM w ill be steeper,fiscal policy will be less effectiv e.8. Follo w ing the reasoning in 7, a positive h giv es a steeper LM. Ifthere are shocks to the IS, a steeper LM will help to stabilizeoutput.9. Lendin g Booms mo ve the LM up and do w n in parallel. Giv en that,it is simple to sho w graphically that a steeper LM stabilizes outputfor the same lending boom. In the figu re we sho w a monetarycontraction, incom e has to fall less with LM 2.[See Figure 1]10. Here y ou w ere supposed to argue what y ou though t was a rationalefor suc h a rule. There is no single correct answ er.3 Fis c a l Questio n s1. The sensitivity of governmen t deman d to output mak es the mul-tiplier fall since it ”automatica lly ” subtracts som e of the dem an dthat autonomous spending plugs in. The in vestmen t subsidy doesthe same, since it is lower when output is higher.2. IngeneralinthismodeltheslopeoftheISisgivenby.δiδY=-1 − c1+ g + skBoth g and s are decreasing the sensitivit y of demand to incomesince they are automatically con tra cting components of demand whenoutput increases or expanding components of demand wh en output falls.In short, it is very difficultforincometomovedemandbecauseithasthese autom atic stabilization m echanisms, small cha ng es in output willrequire big movements in the interest rate to k eep the goods market inequilibriu m. Since s makes the IS steeper it will make output less sensi-tiv e to fluctuation s in investmen t. Consider an expansion in in vestmentdem and for a perfectly steep IS. A t the original income level, both IScurv es will expand v ertically by the same ammount. Since the stabiliza-tion mechanisms tend to limit the effect of the m ultip lie r, equilibriumoutput will expand b y less for the steeper IS.[See Figure 2]33. Now consider an increase in money supply for the t wo IS curv es.An expansiona ry monetary policy will lower in terest rates andhence increase investme nt. To equilibrate the goods mark e t, out-putmustincrease. Sincewehavethisautomaticstabilizationmechanism, the m ultiplier effect will be sm a lle r . Output will in-crease by less and so will the money demand, therefore, in terestrates will fall more.[See Figure 3]4. Same as 2.5. Same as 3.4DynamicQuestions1. A completely elastic money demand.2. If bonds become close substitutes of money, dem and becomes verysensitive to interest rates. For small moveme nts of the in terestrate, people mo ve violently to and from money. If demand formoney is very flat, changes in money demand triggered b y changesin output will not affect the in terest rate very m uch. The LM isvery elastic.3. True. If output is rigid. While output adjusts, in terest rates mustalways equilibrate the money market. Hence, in the short run,the interest rate cannot deviate from the level set by the moneydemand and output slowly adjusts the econom y to its new equilib-rium level.5 Hard P art1.
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