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NATIONAL UNIVERSITY OF SINGAPORE

Department of Economics

EC3102 Macroeconomic Analysis II

Questions and answers prepared by Ho Kong Weng

Tutorial 10

Question 1

A country operating under fixed exchange rates have the following AD and AS:

= TG

P

PEYY ,,

* AD

),1()1( zL

YFPP

e+=

AS

where the partial derivative with respect to the first argument F1 < 0, the partial

derivative with respect to the second argument F2 > 0. Assume that the economy is

initially in the medium run equilibrium with a constant price and output equal to the

natural level of output. Assume that foreign output, foreign price level, and foreign

interest rate are fixed throughout. Assume that domestic expected inflation remains

constant throughout.

(a) Draw the AD-AS diagram.

(b) Suppose there is an increase in government spending. Show the effects on the AD-

AS diagram in the short run and the medium run.

(c) What happens to consumption in the medium run?

(d) What happens to real exchange rate in the medium run? What happens to net exports

in the medium run?

(e) Given the exchange rate is fixed, what is the domestic nominal interest rate? What

happens to real interest rate in the medium run? What happens to investment in the

medium run?

(f) In a closed economy, how does an increase in government spending affect investment

in the medium run?

(g) In an open economy with fixed exchange rates, government spending crowds out

net exports. Explain whether you agree or disagree with the statement.

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Question 2

(a) Suppose there is a permanent 10% increase in M in a closed economy. What is the

effect on the price level in the medium run?

Answer: The price level rises by 10%. This is a standard answer for a closedeconomy. Money is neutral.

(b) Consider an open economy with flexible exchange rates. Suppose there is a 10%

increase in M and the effect on the price level is the same as in part (a). (Suppose money

neutrality holds in an open economy with flexible exchange rates in the sense that the

real exchange rate is not affected by changes in the money stock in the medium run.) If

the real exchange rate and the foreign price level are unchanged in the medium run, what

must happen to the nominal exchange rate in the medium run?

Answer: The real exchange rate is =EP/P*. In the medium run, is unchanged.If

P rises by 10%, E falls by 10%. There is a 10% depreciation of the currency innominal terms.

(c) Suppose it takes n+1 periods to reach the medium run (and everyone knows this.)

Given your answer to part (b), what happens to the expected exchange rate for n+1

periods from now, Eet+n+1, after a 10% increase in the money stock?

Answer: Ee

t+n+1falls by 10%.

(d) Consider the following:

ente

nt

e

tt

e

nt

e

ttt E

iii

iiiE 1**

1

*1

)1)...(1)(1()1)...(1)(1( ++

++

+++++

+++= .

Assume that the foreign interest rates are unchanged for the next n periods. Also,

assume, for the moment, that the domestic interest rates are unchanged for the next n

periods. Given your answer to part (c), what happens to the current exchange rate when

there is a 10% increase in the money stock?

Answer: Current exchange rate Etwill fall by 10%.

(e) Now assume that after the increase in the money stock, the domestic interest rate falls

between time t and time t+n. Again assume that the foreign interest rate is unchanged.

As compared to your answer to part (d), what happens to the current exchange rate?Does the exchange rate moves more in the short run than in the medium run?

Answer:Now the ratio of the domestic interest rates to the foreign interest rates will

decrease. In other words, based on the equation in the tutorial question, current exchange

rate Etwill fall by more than 10%, or more than the depreciation in the medium run. This

phenomenon is called overshooting, and may help to explain why the exchange rate is so

variable.

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Alternatively, looking at the uncovered interest parity, i-i* is approximately equal

expected depreciation. If i falls below i* in the short run, then there is expected

appreciation. This can only happen if Efalls by more than 10% in the short run. In

other words, it is expected that E will appreciate toward the medium run level, which

is a mere 10% decline. So, Efalls by more in the short run than it does in the medium

run.

Question 3

Consider an economy with a fixed exchange rate, E . Suppose, initially, financial market

participants believe that the government is committed to maintaining the fixed exchange

rate. Let UIP stands for uncovered interest parity condition. Now suppose the central

bank announces a devaluation of the currency. The exchange rate will be lowered to a

new level 'E < E . Suppose the financial market participants believe that there is no

further devaluation and the government will remain committed to maintaining the

exchange rate at 'E

.

(a) What is the domestic interest rate before the devaluation? If the devaluation is

credible, what is the domestic interest rate after the devaluation?

(b) Draw the IS-LM-UIP diagrams for this economy. If the devaluation is credible, how

does the expected exchange rate change? How is the UIP curve affected?

(c) How does the devaluation affect the IS curve? Noting your answer to part (b) and the

shift in the IS curve, what would happen to the domestic interest rate if there is no

change in the domestic money supply?

(d) Continue from (c). What must happen to the domestic money supply so that the

domestic interest rate achieves the value identified in part (a)? How does the LM curve

shift?

(e) How is the domestic output affected by the devaluation?

(f) Suppose the devaluation is not credible in the sense that the devaluation leads

financial market participants to expect another round of devaluation in the future. How

does the fear of further devaluation affect the expected exchange rate? How will the

expected exchange rate in this case, where devaluation is not credible, compare to your

answer to part (b)? Explain in words. Given this effect on the expected exchange rate,what must happen to the domestic interest rate, as compared to your answer to part (a),

to maintain the new fixed exchange rate?

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Question 4

Consider the above diagram/economy represented by the following:

IS: Y = C(Y T, confidence) + I(Y, confidence, i + premium) + G

LM: M/P = YL(i)

Interpret the interest rate i as the federal funds rate, which is the policy interest rate of the

Federal Reserve. Assume that there is an unusually high premium added to the federal

funds rate when firms borrow to invest. Assume that C and I are positively related to

confidence. I is negatively related to i + premium. L is negatively related to i. Note that it

is assumed that i cannot be negative but zero at most. Hence, the LM curve has a

horizontal segment before it becomes upward-sloping. The above equation for the LM

curve is meant for the upward-sloping portion.

(a) Suppose the government takes action to improve the solvency of the financial system.

If the governments action is successful, and banks become more willing to lend to one

another and to non-financial firms, what is likely to happen to the premium? Analyze

using the IS-LM diagram.

(b) Faced with a zero nominal interest rate, suppose the Fed decides to purchase

securities directly to facilitate the flow of credit in the financial markets. This policy is

called quantitative easing. If quantitative easing is successful, so that it becomes easier

for financial and non-financial firms to obtain credit, what is likely to happen to the

premium? Analyze using the IS-LM diagram. If quantitative easing has some effect, is it

true that the Fed has no policy options to stimulate the economy when the federal funds

rate is zero?

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Question 5

Consider a bank that has assets of 100, capital of 20, and short-term credit of 80. Among

the banks assets are securitized assets whose value depends on the price of houses.

These assets have a value of 50.

(a) Write down the banks balance sheet.

Suppose as a result of the decline of housing prices, the value of the banks securitized

assets falls by an uncertain amount, so that these assets are now worth somewhere

between 25 and 45. Call the securitized assets troubled assets. The value of the other

assets remains at 50. As a result of the uncertainty about the value of the banks assets,

lenders are reluctant to provide any short-term credits to the bank.

(b) Given the uncertainty about the value of the banks assets, what is the range in the

value of the banks capital?

As a response to this problem, the government considers purchasing the troubled assets,

with the intention of selling them again when the markets stabilize.

(c) If the government pays 25 for the troubled assets, what will be the value of the banks

capital? How much would the government have to pay for the troubled assets to ensure

that the banks capital does not have a negative value? If the government pays 45 for the

troubled assets, but the true value turns out to be much lower, who bears the cost of this

mistaken valuation?

Now, instead of buying the troubled assets, suppose the government provides capital to

the bank by buying ownership shares, with the intention of selling the shares again when

the markets stabilize. The government exchanges treasury bonds (which become assets

of the bank) for ownership shares.

(d) Suppose the government exchange treasury bonds worth 25 for ownership shares.

Assume the worst case scenario that the troubled assets are worth only 25. Set up the

new balance sheet of the bank. What is the total value of the banks capital?

Hint: The bank now has three types of assets.

(e) Why might re-capitalization be a better policy than buying the troubled assets?