14.02. — Fall 2001 — Q UIZ 2STOP! READ INSTRUCTIONS FIRST:• Please, writedownyournameinthetoprightcornerofeverypage.• Read all questions carefully and completely before beginning the exam.• Label all of y our graphs, including axes, clearly; if we can’t read the graph,you will lose points on your answer.• Show your work on all questions in order to receive partial credit.• The quiz is worth a total of 100 points.• No notes, calculators, or books may be used during the quiz.• You will have 2 hours to complete the quiz., although it should take youconsiderably less than that. Good luck!NAME:TA:SECTION/RECITATION TIME:1QUESTION 1: TR UE, FALSE or UNCERTAIN.20 poin tsExplain your answer completely but briefly.1. An expansionary monetary policy lowers the natural rate of output.(5 points)2. When an economy opens to trade and subsequently increases the degreeof competition faced by producers in the final goods market, the naturalrate of unemployment increases.(5 points)3. In a dynamic context, a monetary contraction is followed by an immediateincrease in the interest rate. The new interest rate (at impact) is higherthan the final equilibrium interest rate. (5points)24. There are 2 countries in the world, A and B, which man tain a fixed ex-change agreement. Coun try A has experienced higher GDP growth andhigher inflation than country B. The worsening of A’s trade balance overthis period should come as no surprise. (5 points)3A bonds (domestic investment) B bonds (foreign investment) A bonds (domestic investment) Year t Year t+1 $1 $1 £ £ $ $ Figure 1:QUESTION 2: 40 P oin tsConsider t wo identical economies, A and B, that trade among themselves andthat have flexible exchange rate regimes. Residents have the choice of holdingforeign or domestic bonds with interest rates i* and i. Assume there is perfectcapital mobility, the Marshall-Lerner condition holds (i.e.: a depreciation leadsto an improvement in the trade balance) and the expected future exc hange rateis equal to one.1. State the (uncovered) interest rate parity condition and explain in detailwhat is being arbitraged by filling in the blanks in the diagram above.2. Now assume the government in country A doesn´t like the idea that peoplebuy foreign assets. For that purpose, they impose a tax as follows: For4A bonds (domestic investment) B bonds (foreign investment) A bonds (domestic investment) Year t Year t+1 $1 $1 £ £ $ $ Figure 2:every unit of domestic currency used to purchase foreign currency, theymust pay a tax t (also in domestic currency). Fill in the blanks in thediagram above, and use it to determine the new interest parity condition.3. Let us now go back to the initial situation (i.e.: no tax on purchases offoreign currency). Suppose income taxes in country A are increased. Plotthe IS-LM graphs for both coun t ries, indicating any changes in them as aresult of this new policy.5Axis: Axis: 4. Fill in the blanks of this chart with symbols indicating whether each of thefollowing variables increases (+), decreases (-), remains unaffected (=)orcannot be determined (?).Ya YbCa CbNXa NXbIa IbEa Eb6QU EST ION 3: Small versus Large Econom y (40 poin ts)Suppose there are two types of countries in the world, small and large. Thebehavioral equations for the small country are:C = αYI = βY − γiG given (exogenous)NX = δY∗− λY − µs1Ewhere the superscript ”s” denotes small, and we have assumed that prices arefixed so e = E. There are similar behavioral equations for the large country:µs>µl.1. What does our theory tell us about the relation between E (defined as inclass and textbook) and net exports?2. Now suppose Eet+1=_E =1. Also suppose that the world interest rateis described by: i∗=(1− as)_i∗+ asi,where_i∗is dependent on economicconditions in rest of world and asis the weight of the domestic interestrate for the small country.(i) Use the arbitrage condition from trading domestic versus foreign assetsand derive E as a function of i.PlotwithE on the y-axis.(ii) Plot on the same graph the relation for a large coun try, that is al>as.Interpret the different slopes. Where do the two curves intersect?7Axis: Axis: 3. Now solve for the goods market equilibrium in each country. What is theslope of the IS (with i on the y-axis)?. Plot the two curves for a small andlarge coun try respectively (µlversus µs). How do they compare?8Axis: Axis: 4. Now include a standard LM curve in the same (i,Y ) space. Analyze theeffect of a monetary expansion in the two countries. In which country ismonetary expansion more effectiv e (in terms of altering Y )?9Axis: Axis: 5. Now analyze the effects of a fiscal expansion in either country. Where isfiscal policy more effective?10Axis: Axis: 6. Now, assume investment in the small country does not depend only uponthe interest rate and the level of output as usual. Investment in the smallcoun try will also depend on the cost of in termediate goods, whose priceis completely determined by the exchange rate. How does this change theIS and the LM if at all? Does this affect the effectiveness of a c hange inmonetary policy?11Axis: Axis:
View Full Document
Unlocking...