Economics H201

							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
                    Canada                                C$2.85
                    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./$)
                Canada
                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
           Canada                           1.47 C$/$
           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.
                                      9


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.