# Economics H201

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```					1. Big Mac Exchange Rates

Country       Local Price
United States             \$2.51
Czech Republic     Koruna54.37
Indonesia         Rupiah14,500
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).

eP           P*
PPP requires E  *  1  e 
P            P
In each case P indicates the U.S. price of \$2.51, and
P* denotes the foreign currency price. The resulting
calculations are in the table below.

Country     Predicted Exch.
Rate
(Local Cur./\$)
Czech Republic 21.66 Koruna/\$
Indonesia    5776.89 Rupiah/\$
Switzerland       2.35SFr./\$
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.

The real exchange rate is governed by:

eP     e
E *  *
P   P /P
In part (a), we calculated P*/P. Now divide the nominal
exchange rates in the table below by the predicted real
exchange rates from part (a) to give us:

Country        Actual Nominal      U.S. \$ Real
Exchange Rate       Exchange
Rate
Czech Republic      39.1 Koruna/\$         1.81
Indonesia           7,945 Rupiah/\$        1.38
Switzerland           1.70 SFr/\$          0.72
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.
Real Interest Rate                     Real Interest Rate
LFS:S

r*
NCO
LFD: I + NCO

Q. of Loanable Funds                       NCO
Real Exchange Rate

Supply of Dollars: NCO

E*
Demand for Dollars: NX

Q. of Dollars
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                       NCO
Real Exchange Rate

Supply of Dollars: NCO
E*

Demand for Dollars: NX

Q. of Dollars
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.

No. The tax increase reduces the government budget
deficit. However, the tax increase would predict an
improvement in the trade balance. This is in conflict
with the experience the question refers to.

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.

Yes. The tax increase implies an improvement in the
government budget deficit. Since the two
disturbances predict opposite movements in the trade
balance, the two effects could approximately cancel
each other out.
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
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.

The value of money increases. Therefore, the price
level must decreases.
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.

The decrease in the money supply increases the
interest rate.

Interest Rate

Money Supply

Money Demand
Quantity of Money
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? Explain briefly.

Aggregate Price Level

Aggregate Supply

P0
Aggregate Demand

Real GDP
Y0

The increase in the real interest rate shifts the AD
curve to the left. Output decreases and the price level
also decreases.
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.

In part (b) of question #2, we showed that a foreign
debt crisis would increase the value of the dollar.
Domestic residents want to buy more foreign goods
and foreigners want to buy less of our exports. The
aggregate demand curve therefore shifts to the left.
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.

Increase the money supply, reduce taxes, or increase
government spending. All of these policies can
restore the AD curve to its original position. In the
diagram below, the red arrow shows the effect of the
disturbance, while the blue arrow shows the effect of
the policy.

Aggregate Price Level

Aggregate Supply

P0
Aggregate Demand

Real GDP
Y0
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.

Increase the money supply, reduce taxes, or
increase government spending.
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

Over time, the reduction in the price level begins to
reduce expected prices. As expected prices decrease,
the AS curve shits to the right.
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.

The reduction in Y and the reduction in P both reduce
the demand for dollars for transaction purposes. The
money demand curve shifts left.

Interest Rate

Money Supply

Money Demand
Quantity of Money
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.

Real Interest Rate
Supply of Loanable Funds

Demand for Loanable Funds

Quantity of Loanable Funds

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