NATIONAL UNIVERSITY OF SINGAPOREDepartment 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: EP Y = Y * , G, T P AD Y AS , z) L 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. P = P e (1 + µ ) F (1 − (a) Draw the AD-AS diagram. (b) Suppose there is an increase in government spending. Show the effects on the ADAS 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. based on the equation in the tutorial question. (c) Suppose it takes n+1 periods to reach the medium run (and everyone knows this. . Again assume that the foreign interest rate is unchanged.. Et = (1 + it* )(1 + it*+e1 ). There is a 10% depreciation of the currency in nominal terms. ε is unchanged. what must happen to the nominal exchange rate in the medium run? Answer: The real exchange rate is ε = EP/P*. for the moment. that the domestic interest rates are unchanged for the next n periods.) Given your answer to part (b). assume.(1 + it*+en ) Assume that the foreign interest rates are unchanged for the next n periods.Question 2 (a) Suppose there is a permanent 10% increase in M in a closed economy. or more than the depreciation in the medium run.) If the real exchange rate and the foreign price level are unchanged in the medium run. (e) Now assume that after the increase in the money stock. (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. (b) Consider an open economy with flexible exchange rates. Also. current exchange rate Et will fall by more than 10%. This is a standard answer for a closed economy. after a 10% increase in the money stock? Answer: Eet+n+1 falls by 10%. the domestic interest rate falls between time t and time t+n. As compared to your answer to part (d). This phenomenon is called overshooting. Money is neutral. (d) Consider the following: (1 + it )(1 + ite+1 ). Eet+n+1. E falls by 10%.. If P rises by 10%. Suppose there is a 10% increase in M and the effect on the price level is the same as in part (a). and may help to explain why the exchange rate is so variable.. In the medium run. 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. What is the effect on the price level in the medium run? Answer: The price level rises by 10%. what happens to the current exchange rate when there is a 10% increase in the money stock? Answer: Current exchange rate Et will fall by 10%.. what happens to the expected exchange rate for n+1 periods from now. Given your answer to part (c).(1 + ite+ n ) e Et + n +1 . This can only happen if E falls by more than 10% in the short run. i-i* is approximately equal expected depreciation. which is a mere 10% decline. The exchange rate will be lowered to a new level E ' < E . How does the fear of further devaluation affect the expected exchange rate? How will the expected exchange rate in this case. then there is expected appreciation. Given this effect on the expected exchange rate.Alternatively. what would happen to the domestic interest rate if there is no change in the domestic money supply? (d) Continue from (c). E falls by more in the short run than it does in the medium run. Let UIP stands for uncovered interest parity condition. what must happen to the domestic interest rate. looking at the uncovered interest parity. If the devaluation is credible. compare to your answer to part (b)? Explain in words. In other words. If i falls below i* in the short run. E . Now suppose the central bank announces a devaluation of the currency. initially. it is expected that E will appreciate toward the medium run level. So. Suppose. Question 3 Consider an economy with a fixed exchange rate. (a) What is the domestic interest rate before the devaluation? If the devaluation is credible. 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 ' . to maintain the new fixed exchange rate? . where devaluation is not credible. 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. what is the domestic interest rate after the devaluation? (b) Draw the IS-LM-UIP diagrams for this economy. financial market participants believe that the government is committed to maintaining the fixed exchange rate. 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. as compared to your answer to part (a). If quantitative easing has some effect. I is negatively related to i + premium. (a) Suppose the government takes action to improve the solvency of the financial system.Question 4 Consider the above diagram/economy represented by the following: IS: Y = C(Y – T. 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. confidence. i + premium) + G LM: M/P = YL(i) Interpret the interest rate i as the federal funds rate. If quantitative easing is successful. The above equation for the LM curve is meant for the upward-sloping portion. what is likely to happen to the premium? Analyze using the IS-LM diagram. Assume that there is an unusually high premium added to the federal funds rate when firms borrow to invest. L is negatively related to i. Assume that C and I are positively related to confidence. and banks become more willing to lend to one another and to non-financial firms. the LM curve has a horizontal segment before it becomes upward-sloping. This policy is called quantitative easing. suppose the Fed decides to purchase securities directly to facilitate the flow of credit in the financial markets. confidence) + I(Y. If the government’s action is successful. Note that it is assumed that i cannot be negative but zero at most. which is the policy interest rate of the Federal Reserve. (b) Faced with a zero nominal interest rate. Hence. is it true that the Fed has no policy options to stimulate the economy when the federal funds rate is zero? . Question 5 Consider a bank that has assets of 100. Suppose as a result of the decline of housing prices. with the intention of selling the shares again when the markets stabilize. what is the range in the value of the bank’s capital? As a response to this problem. As a result of the uncertainty about the value of the bank’s assets. what will be the value of the bank’s capital? How much would the government have to pay for the troubled assets to ensure that the bank’s capital does not have a negative value? If the government pays 45 for the troubled assets. What is the total value of the bank’s capital? Hint: The bank now has three types of assets. so that these assets are now worth somewhere between 25 and 45. (d) Suppose the government exchange treasury bonds worth 25 for ownership shares. The government exchanges treasury bonds (which become assets of the bank) for ownership shares. These assets have a value of 50. Assume the worst case scenario that the troubled assets are worth only 25. who bears the cost of this mistaken valuation? Now. (c) If the government pays 25 for the troubled assets. (e) Why might re-capitalization be a better policy than buying the troubled assets? . Set up the new balance sheet of the bank. with the intention of selling them again when the markets stabilize. Among the bank’s assets are securitized assets whose value depends on the price of houses. and short-term credit of 80. instead of buying the troubled assets. Call the securitized assets “troubled assets. (b) Given the uncertainty about the value of the bank’s assets. capital of 20. suppose the government provides capital to the bank by buying ownership shares. the government considers purchasing the troubled assets. lenders are reluctant to provide any short-term credits to the bank. the value of the bank’s securitized assets falls by an uncertain amount. (a) Write down the bank’s balance sheet.” The value of the other assets remains at 50. but the true value turns out to be much lower.