14.02 Principles of Macroeconomics Problem Set #8, Questions Posted on Thursday, December 5, 2002, due on Wednesday, December 12, 2002. You must staple a copy of this frontpage on your problem set. Remember to write down your TAs section name and recitation time, your name and MIT ID. Name: __________________________________________________ MIT ID: __________________________________________________ 10AM Samer Haj-Yehia 9AM Indradeep Ghosh 11AM Samer Haj-Yehia 11AM Oscar Landerretche 12AM Samer Haj-Yehia 1PM Indradeep Ghosh 1PM Samer Haj-Yehia 1PM Verónica Rappoport 2PM Samer Haj-Yehia 2PM Verónica Rappoport 3PM Verónica Rappoport (Table is for corrector use only) 1 2 3 Total I II III TotalPART I. SHORT QUESTIONS (5 points each) 1. T/F/U (justify your answer). The bilateral exchange rate between US and Japan is 124 (1$ can buy 124 ¥). Therefore, American tourists in Japan find everything very cheap. 2. T/F/U (justify your answer). Devaluation is always associated with gains in competitivity. 3. Complete the blanks: Current Account Export 1000 Imports _____ _____________________ -500 Investment income received 300 Investment income paid _____ _____________________ -100 Net transfers received 50 Current Account balance _____ Capital Account __________________________________ 500 Increase in US holdings of foreign assets _____ Net Capital Inflows _____ PART II. OPEN ECONOMY WITHOUT CAPITAL MOBILITY (15 points each) Imagine a small open economy in a world of no capital mobility. The economy is characterized by the following behavioral equations: C = c0 + c1 (Y-T) I = b0 + b1Y – b2 i G = G0 T = T0 X = x0 + x1Y* + x2 ε IM = q0 + q1 Y – q2 ε Md = m0 + m1Y – m2 i Ms = M0 Where Y* is the level of foreign output and ε is the real exchange rate.1. What is the total demand for domestic goods? What is the trade balance? Plot the IS and the LM curves in the (Y,i) space and the trade balance in the (XN, Y) space, assuming that at the equilibrium point the trade balance is zero and the output is at its natural level. 2. Now, assume that at the equilibrium point, the output is below its natural level and there is trade deficit. Explain under what conditions a real depreciation can improve the situation. Use a graph and provide intuition. 3. What policies would you recommend if at the natural output level the economy runs trade deficits? PART III. OPEN ECONOMY WITH PERFECT CAPITAL MOBILITY (10 points each) True/False/Uncertainty. Justify your answer intuitively and graphically using the IS/LM/BP model. 1. In a small open economy under fixed exchange rate, monetary policy is extremely effective in altering the output level. 2. In a small open economy under flexible exchange rate, monetary policy is extremely effective in altering the output level. 3. Flexible exchange rate is better than fixed exchange rate regimes in stabilizing domestic output against fluctuations in international output
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