Homework ch 27 ECO 201: Principles of Macroeconomics Questions 2, 3 Exercises 2, 4, 5, 8 Note for Question 2 Hint: See the section “The determination of the exchange rate in the short run.” Hint for Question 3 A lower interest makes the country’s assets ________ (more/less) attractive, which ________ (increases/decreases) the demand for the country’s currency, which ________ (appreciates/depreciates) the exchange rate. This change in the exchange rate ________ (encourages/discourages) exports and ________ (encourages/discourages) imports, leading to ________ (higher/lower) output. This ________ (strengthens/weakens) the direct effect of interest rates on output we studied before. Note for Exercises 2 and 8 We did a couple of similar exercises in class. Note for Exercise 4 Notice you are asked about the value of the dollar. Economics is about thinking carefully and methodically. That’s what you need to do here. How does each event encourage or discourage people from buying or selling US goods, services, or assets? Foreign goods, services, or assets? Here are two answered problems: a. U.S. assets become less attractive because they seem riskier, so the demand for dollars falls. The dollar depreciates. e. Financial investors would anticipate that the Fed will lower interest rates, making U.S. financial assets less attractive. The demand for dollars falls and the dollar depreciates. This effect may be offset to some degree by the impending recession itself, which would be expected to lower the U.S. demand for imports (because income and spending falls), and hence reduce the supply of dollars, putting upward pressure on the dollar. Note for Exercise 5 Here’s a similar problem to what you are being asked to do, with different numbers. I’m giving you this problem so you get a firm idea of what you are supposed to do.Suppose demand and supply are given by Demand for pesos D = 25,000 – 50,000e Supply of pesos S = 17,600 + 24,000e The equilibrium value of the currency is 25,000 – 50,000e = 17,600 + 24,000e 7,400 = 74,000e e = 0.10 Suppose the fixed value of the peso is 0.05 dollars per peso. Then it’s clear that the peso is undervalued: it should be worth more, but the government fixes a low value for it. The balance of payments is given by the difference between the quantity supplied and the quantity demanded of pesos. An excess demand is equivalent to a BOP surplus. Demand for pesos @ e =0.05 D = 25,000 – 50,000(0.05) = 22,500 Supply of pesos @ e = 0.05 S = 17,600 + 24,000(0.05) = 18,800 The excess demand is 3700 pesos, so the BOP surplus is 3700. Every period the Central bank will have to supply 3700 (to eliminate the excess demand), buying the corresponding dollars. At the exchange rate of 0.05 dollars per peso, this is equivalent to 3700*0.05 = $185. International reserves will rise by $185 every year. Notice that money supply grows by 3700 pesos every year, regardless of whether there’s a recessionary gap (which would call for an monetary expansion) or an expansionary gap (which would call for a money supply contraction). ------- Suppose the fixed value of the peso is 0.25 dollars per peso. Then it’s clear that the peso is overvalued: it should be worth less, but the government fixes a high value for it. The balance of payments is given by the difference between the quantity supplied and the quantity demanded of pesos. An excess supply is equivalent to a BOP deficit. Demand for pesos @ e =0.25 D = 25,000 – 50,000(0.25) = 12,500 Supply of pesos @ e = 0.25 S = 17,600 + 24,000(0.25) = 23,600 The excess supply is 11,100 pesos, so the BOP deficit is 11,100. Every period the Central bank will have to demand 3700 (to eliminate the excess supply), selling the corresponding dollars. At the exchange rate of 0.25 dollars per peso, this is equivalent to 11,100*0.25 = $2775. International reserves will fall by $2775 every