# Economics H201 by we9mj6AB

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```									Economics H201
Professor S. McCafferty
Sample Problems III

1. The April 29, 2000 issue of The Economist lists the following data on McDonald’s
Big Mac prices in various countries.

Country                  Local Price
United States                          \$2.51
Czech Republic                  Koruna 54.37
Indonesia                      Rupiah 14,500
Switzerland                          SFr5.90

a.)     For each country, calculate the U.S. nominal exchange rate against the
relevant currency that would be predicted by purchasing power parity (PPP).

Country               Predicted Exch. Rate
(Local Cur./\$)
Czech Republic
Indonesia
Switzerland

b.)     The table below indicates each country’s actual nominal exchange rate at the
time. Calculate the U.S. real exchange rate vs. each country.

Country               Actual Nominal           U.S. \$ Real
Exchange Rate           Exchange Rate
Czech Republic                39.1 Koruna/\$
Indonesia                     7,945 Rupiah/\$
Switzerland                     1.70 SFr/\$

2. For this problem, assume that the level of U.S. real GDP and the aggregate U.S. price
level are given. Also assume that Ricardian Equivalence does not hold, so that changes
in the government budget deficit do affect national saving.

a.)     Now suppose that the government increases taxes, but does not change the
level of government spending. In the diagram below, show the effects of the
tax increase on the U.S. real interest rate, real exchange rate, and trade
balance. Explain briefly.
2

Real Interest Rate                         Real Interest Rate
LFS:S

r*

NCO
LFD: I + NCO

Q. of Loanable Funds                           NFI
Real Exchange Rate

Supply of Dollars: NCO
E*
Demand for Dollars: NX

Q. of Dollars
3

b.)    Assume that the tax increase in part a.) is not implemented. Instead assume
that there is a debt crisis involving some foreign developing economies. That
is, there is a flight of capital away from the developing countries in favor of
safer assets, like those denominated in U.S. dollars. In the diagram below,
show the effects of this development on the U.S. real interest rate, real
exchange rate, and trade balance. Explain briefly.

Real Interest Rate                             Real Interest Rate
LFS:S

r*

NCO
LFD: I + NCO

Q. of Loanable Funds                               NFI
Real Exchange Rate

Supply of Dollars: NCO
E*
Demand for Dollars: NX

Q. of Dollars
4

In the past several years, the U.S. government budget deficit has gotten much smaller,
and has recently gone into surplus. At the same time, the U.S. trade deficit has not
changed appreciably.

c.)     Could recent increases in U.S. tax rates explain both of these phenomena?
Explain.

d.)     Could a simultaneous increase in U.S. tax rates and foreign debt crises (capital
flight in many of the developing countries) explain both of these phenomena?
Explain.

3. The role of money in the classical macroeconomic model is quite different from the
role of money in the model of aggregate demand and aggregate supply.

a.)     In the diagram below, show the effect of a reduction in the money supply on
the equilibrium value of money in the classical macroeconomic model.
Explain briefly.

Value of
Money

Money Supply

Money Demand
Quantity of Money
5

b.)   What is the effect of this reduction in the money on the level of prices? What
is the effect of this reduction in the money supply on the interest rate?
Explain briefly.

c.)   In the graph below, show the effect of this reduction in the money supply on
the level of the interest rate in the model of aggregate demand and aggregate
supply.

Interest Rate

Money Supply

Money Demand

Quantity of Money
6

d.)   What is the effect of this reduction in the money supply on the level of prices
in the model of aggregate demand and aggregate supply? Demonstrate this
effect in the diagram below. Explain briefly.

Aggregate Price Level

Aggregate Supply

P0
Aggregate Demand

Real GDP
Y0
7

4. There has been some recent concern that foreign debt crises could generate a
recession in the U.S.

a.)     Use aggregate demand and supply analysis to critically evaluate this
argument. You should center your discussion on the effects of this
development using the graph below.

Aggregate Price Level

Aggregate Supply

P0
Aggregate Demand

Real GDP
Y0

b.)     Suppose you wanted to use monetary policy to offset the effects of this
disturbance on the U.S. economy. What kind of policy (policies) would be
appropriate? Explain. Illustrate the combined effects of the disturbance and
the policy in the graph below.

Aggregate Price Level

Aggregate Supply

P0
Aggregate Demand

Real GDP
Y0
8

5. Consider an economy that starts out in both short-run and long-run equilibrium. That
is the level of output and the level of prices are consistent with the short-run of the
aggregate demand and aggregate supply model of the economy and with the classical
macroeconomy. Now suppose that consumers decide to save more and spend less on
consumption. Perhaps they do this because they suddenly begin to be fearful about the
likelihood that they will actually receive Social Security benefits when they retire.

a.)    In the diagram below, show the short-run effect of this development on the
level of real GDP and the level of prices in the short-run.

Price Level

Short-Run Aggregate Supply

P1

Aggregate Demand

Quantity of
Y1                    Real Output

b.)    Suppose that you wanted to implement a government policy to immediately
offset the effect of this disturbance on the level of real GDP. Give at least one
example of a policy that would accomplish this. Explain briefly.
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c.)   Suppose that the policy (policies) that you suggested in part (b) of this
question is (are) not implemented. In the diagram below, show the position of
the economy in the long-run. Specifically, what shift(s) in aggregate demand
and/or aggregate supply bring the economy to its long-run equilibrium
position. Explain briefly.

Price Level            Long-Run Aggregate Supply

Short-Run Aggregate Supply

P1

Aggregate Demand

Quantity of
Y1                   Real Output

d.)   In the short-run, what is the effect of the reduction in consumption spending
on the level of interest rates? To illustrate your answer, correctly use the
graph that is most appropriate. Explain briefly.

e.)   In the long-run, what is the effect of the reduction in consumption spending
on the level of interest rates? To illustrate your answer, correctly use the
graph that is most appropriate. Explain briefly.

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