STUDY GUIDE FINAL ECO41 FALL 2010 UDAYAN ROY

The final test will be held on Wednesday, December 22, 9:00 – 10:40.

It will consist of mostly multiple-choice questions plus a few fill-in-the-blanks questions.

The questions will be based on:

Chapters 1 – 10 of my lecture notes, and the following sections of the course’s textbook:

Chapter 12:all of it

Chapter 13:Exchange Rates and International Transactions
The Demand for Foreign Currency Assets
Equilibrium in the Foreign Exchange Market
Interest Rates, Expectations, and Equilibrium

Chapter 14:Aggregate Money demand,
The Equilibrium Interest Rate: The Interaction of Money Supply and Money demand, Money, the Price Level, and the Exchange Rate in the Long Run

Chapter 15:The Law of One Price
Purchasing Power Parity
A Long-Run Exchange Rate Model Based on PPP
Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates
International Interest Rate Differences and the Real Exchange Rate, Real Interest Parity

Chapter 17: How the Central Bank Fixes the Exchange Rate
Stabilization Policies with a Fixed Exchange Rate

I will be posting practice questions on the course’s Web site at both this week and next week. Many of these practice questions may reappear in the final. You will have to find the answers on your own.

Please also visit the web page to check your records. Please let me know if you see any errors.

I have provided some practice questions below. I will not provide the answers to the questions whose answers are not provided here. I will hold my office hours, and will be reachable by phone and email.

December 17, 2010

National Income Accounting—based on Ch 12 of the course’s textbook

A country’s ____ is the market value of all final goods and services produced (for sale) by the factors of production (or, resources) owned by the permanent residents (or, nationals) of the country in a given time period.

  1. Gross Domestic Product
  2. Gross National Product
  3. Net Domestic Product
  4. National Income

A country’s ____ is the market value of all final goods and services produced (for sale) within the country in a given time period.

  1. Gross Domestic Product
  2. Gross National Product
  3. Net Domestic Product
  4. National Income

As in the textbook, let Y stand for GNP, C for consumption spending, I for investment spending, G for government purchases, EX for exports, IM for imports, and CA for the current account balance. Then the national income identity for the open economy is

  1. Y = C + I + G.
  2. Y = C + I + G + EX + IM.
  3. Y = C + I + G + EX – IM.
  4. Y = C + I + G – CA.

Let T denote the government’s net tax revenue. (That is, T = tax revenues – transfer payments (or, gifts) from the government to others. This is the government’s income.) Then national saving (S) is given by

  1. S = Y – T – C
  2. S = Y – C
  3. S = Y – C – G
  4. S = T – G

Let Sp denote the private sector’s saving. Then

  1. Sp = Y – T – C
  2. Sp = Y – C
  3. Sp = Y – C – G
  4. Sp = T – G

Let Sg denote the government’s saving (also called the budget surplus). Then

  1. Sg = Y – T – C
  2. Sg = Y – C
  3. Sg = Y – C – G
  4. Sg = T – G

The national income identity for the open economy can be re-written as

  1. CA = S + I; therefore, a country can have a current account surplus only if it saves and invests more
  2. CA = S – I; therefore, a country can have a current account surplus only if it saves more than its businesses invest
  3. CA = I – S; therefore, a country can have a current account surplus only if it saves less than its businesses invest
  4. None of the above. A country’s saving must be equal to its investment.

Let T be the net tax revenues of the government. That is, T = tax revenues – transfer payments (such as, pensions for retirees, unemployment benefits, cash grants for poor people, etc.). Also, let S, Sp, and Sg represent national saving, private saving and government saving. Which of the following is correct?

  1. S = Sp + Sg.
  2. S – I = CA.
  3. Sp = I + CA – (T – G).
  4. All of the above
  5. None of the above.

Balance of Payments Accounting—based on Ch 12 of the course’s textbook

For the United States, the balance on financial account in 2006 was +$833.2 billion. Therefore,

  1. Americans lent more money to foreigners in 2006 than they borrowed from foreigners.
  2. Americans lent less money to foreigners in 2006 than they borrowed from foreigners.
  3. Americans lent the same amount of money to foreigners in 2006 than they borrowed from foreigners; the balance on financial account is not about lending and borrowing
  4. More information would be needed to compare the amount lent by Americans to the amount borrowed by Americans.

The balance of payments accounts are made up of

  1. the current account and the capital account
  2. the current account and the financial account
  3. the current account, the capital account and the financial account
  4. the current account, the capital account, and the official reserve transactions account

Credits items in the balance of payments correspond to transactions that:

  1. Involve receipts from foreigners.
  2. Involve payments to foreigners.
  3. Decrease the domestic money supply.
  4. Increase the demand for foreign exchange.

Which of the following is considered a credit in the financial account?

  1. A sale of U.S. financial assets to a foreign buyer.
  2. A loan from a U.S. bank to a foreign borrower.
  3. A purchase of foreign financial assets by a U.S. buyer.
  4. A U.S. citizen’s repayment of a loan from a foreign bank.

The balance of any of the accounts within the balance of payments accounts equals:

  1. the total of all credits
  2. the total of all debits
  3. total credits – total debits
  4. total debits – total credits

The Fundamental Balance of Payments Identity is that if we ignore any statistical discrepancy, then it is always true that

  1. Balance on current account + balance on capital account = 0
  2. Balance on current account + balance on financial account = 0
  3. Balance on current account + balance on capital account + balance on financial account = 0
  4. Balance on current account + balance on capital account + balance on official reserve transactions account = 0

In a country’s balance of payments, which of the following transactions are debits?

  1. A decrease in the domestic bank balances of foreigners.
  2. A decrease in the foreign bank balances of domestic residents.
  3. Sale of assets by domestic residents to non-residents.
  4. Sale of goods by domestic residents to non-residents.

Foreign exchange market—based on chapter 13 of the textbook

How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing £50 if the exchange rate is $1.50 per one British pound (£)? $______

How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.80 dollars per one British pound? $______

If the price of a British pound increases from $1.50 per pound to $1.80 per pound, we say that:

  1. The dollar has appreciated and the pound has depreciated
  2. the dollar has depreciated and the pound has appreciated
  3. the dollar has appreciated and the pound has appreciated
  4. the dollar has depreciated and the pound has depreciated

When the price of a British pound increases from $1.50 per pound to $1.80 per pound,

  1. Americans find that Britain’s exports are more expensive, and British residents find that imports from America are more expensive.
  2. Americans find that Britain’s exports are more expensive, and British residents find that imports from America are less expensive.
  3. Americans find that Britain’s exports are cheaper; however, British residents are not affected.
  4. Americans are not affected, but British residents find that imports from America are more expensive.
  5. None of the above.

An appreciation of a country’s currency

  1. Decreases the relative price of its exports and lowers the relative price of its imports.
  2. Raises the relative price of its exports and raises the relative price of its imports.
  3. Lowers the relative price of its exports and raises the relative price of its imports.
  4. Raises the relative price of its exports and lowers the relative price of its imports.
  5. None of the above.

The exchange rate between currencies depends on

  1. The interest rates that can be earned on deposits in those currencies.
  2. The expected future exchange rate.
  3. The interest rates that can be earned on deposits in those currencies and the expected future exchange rate.
  4. National output.
  5. None of the above.

If the interest rate on dollar deposits is 10 percent and the interest rate on euro deposits is 6 percent, then

  1. An investor should invest only in dollar deposits.
  2. An investor should invest only in euro deposits.
  3. An investor should be indifferent between dollar deposits and euro deposits.
  4. It is impossible to tell given the information.

Which of the following statements is the most accurate?

  1. A rise in the interest rate on dollar bank deposits (R$) causes the dollar to appreciate.
  2. A rise in the interest rate on dollar bank deposits (R$) causes the dollar to depreciate.
  3. A rise in the interest rate on dollar bank deposits (R$) does not affect the U.S. dollar.
  4. For a given euro interest rate (R€) and constant expected exchange rate (Ee$/€), a rise in the interest rate on dollar deposits (R$) causes the dollar to appreciate.
  5. None of the above.

If the interest rate paid by US banks (R$) is 6 percent and the interest rate paid by European banks (R€) is 4 percent, the theory of interest parity says that people probably expect

  1. The dollar to appreciate by 2 percent
  2. The euro to appreciate by 2 percent
  3. The dollar to appreciate by 10 percent
  4. The euro to appreciate by 10 percent

What is equation that represents the interest parity condition?

  1. R$ = R€ + (Ee$/€ – E$/€) / E$/€.
  2. R€ = R$ + (Ee$/€ – E$/€) / E$/€.
  3. R$ = R€ + (Ee€/$ – E€/$) / E€/$.
  4. R$ = R€ - (Ee$/€ – E$/€) / E$/€.

If all interest rates stay unchanged, the theory of interest parity says that an increase in the expected future value of the euro (Ee$/€)

  1. Will cause the value of the euro (E$/€) to increase immediately
  2. Will cause the value of the euro (E$/€) to decrease immediately
  3. Will have no immediate effect on the value of the euro (E$/€)
  4. Will cause the value of the euro (E$/€) to increase, but only in the long run

When the interest parity equation is satisfied,

  1. The goods market is in equilibrium
  2. The money market is in equilibrium
  3. The foreign exchange market is in equilibrium
  4. All of the above
  5. None of the above

Money market—based on chapter 14 of the textbook

The aggregate money demand (Md) depends on

a. The interest rate (R)

b. The price level (P)

c. Real national income (Y)

d. All of the above.

e. Only (a) and (c)

The aggregate money demand (Md) _____ when Y increases, ______when R increases, and ______when P increases. Fill in the blanks using any or all of the following answers: increases, decreases, stays unchanged.

The requirement that the real supply of money (Ms/P) must equal the real demand for money (L) implies that the domestic interest rate (R) will rise if:

a. Ms↓ or P↑ or Y↑ or some combination of these changes occurs.

b. Ms↑ or P↓ or Y↑ or some combination of these changes occurs.

c. Ms↑ or P↓ or Y↓ or some combination of these changes occurs.

d. None of the above.

A rise in

a. real GNP (Y) decreases aggregate real money demand (L) for any given interest rate (R), thereby moving the L(R,Y) curve to the right.

b. real GNP raises aggregate real money demand for any given interest rate, moving the L(R,Y) curve to the left.

c. real GNP raises aggregate real money demand for any given interest rate, moving the L(R,Y) curve to the right.

d. nominal GNP raises aggregate real money demand for a given interest rate, moving the L(R,Y) curve to the right.

e. real GNP raises aggregate nominal money demand for a given interest rate, moving the L(R,Y) curve to the right.

The real money supply (Ms/P) curve is

a. horizontal because MS is set by the central bank while P is taken as given.

b. vertical because MS is set by the central bank.

c. vertical because MS is set by the households and firms while P is taken as given.

d. horizontal because MS and P are set by the central bank.

e. vertical because MS is set by the central bank while P is taken as given.

Which of the following is accurate?

a. As the left panel of the figure above shows, an increase in the supply of money reduces the interest rate, provided the price level and the real GNP are unchanged.

b. As the right panel of the figure above shows, an increase in the supply of money raises the interest rate, provided the price level and the real GNP are unchanged.

c. As the left panel of the figure above shows, an increase in the supply of money raises the interest rate, provided the price level and the real GNP are unchanged.

d. As the right panel of the figure above shows, an increase in the supply of money reduces the interest rate, provided real GNP is unchanged.

e. None of the above.

Which of the following is accurate?

a. As the left panel of the figure above shows, an increase in real GNP reduces the interest rate, provided the price level and the supply of money are unchanged.

b. As the right panel of the figure above shows, an increase in real GNP raises the interest rate, provided the price level and the supply of money are unchanged.

c. As the left panel of the figure above shows, an increase in real GNP raises the interest rate, provided the price level and the supply of money are unchanged.

d. As the right panel of the figure above shows, an increase in real GNP reduces the interest rate, provided the supply of money is unchanged.

e. None of the above.

The requirement that the real supply of money (Ms/P) must equal the real demand for money (L) implies that the domestic interest rate (R) will rise if:

a. Ms↓ or P↑ or Y↑ or some combination of these changes occurs.

b. Ms↑ or P↓ or Y↑ or some combination of these changes occurs.

c. Ms↑ or P↓ or Y↓ or some combination of these changes occurs.

d. None of the above.

We saw in the discussion of interest parity in Chapter 13 that R = R* + (Ee – E)/E, where R is the domestic interest rate, R* is the foreign interest rate, and Ee is the expected future value of the foreign currency. This implies that the value of the foreign currency (E) will rise if:

a. R↓ or R*↑ or Ee↑ or some combination of these changes occurs.

b. R↑ or R*↑ or Ee↑ or some combination of these changes occurs.

c. R↓ or R*↑ or Ee↓ or some combination of these changes occurs.

d. None of the above.

Combining the themes of Chapter 13 and of this chapter that were discussed in the last 2 questions, we can say that the value of the foreign currency (E) will rise if:

a. Ms↓ or P↑ or Y↑ in the US, or Ee↑ or some combination of these changes occurs.

b. Ms↑ or P↓ or Y↓ in the US, or Ee↑ or some combination of these changes occurs.

c. Ms↓ or P↑ or Y↑ in either the US or in Europe, or Ee↑ or some combination of these changes occurs.

d. None of the above.

In the first column of the table below, please list all the three main variables that affect the quantity of money demanded (Md). (Please specify the symbols that represent the variable plus the descriptive name of the variable; for example: “E, the price of the foreign currency in units of the domestic currency.”) In the second column, specify whether Mdincreasesor decreases when the variable you listed in the first column increases.

When this variable increases … / Md …

In the second column of the Table below, indicate whether a permanent increase in Ms, the quantity of money circulating in the economy, will lead to an increase (↑), a decrease (↓), an ambiguous change (?), or no change (0) in the variables listed in the first column in the long run. In the third column of the attached table, indicate whether a permanent increase in the growth rate of Ms will lead to an increase, a decrease, an ambiguous change, or no change in the variables listed in the first column in the long run.

Long run effect of an increase in …
Money supply / Growth rate of money supply
π, the inflation rate
E

Assume floating (flexible) exchange rates. When doing the second column, assume that growth of money supply is unchanged at the time the money supply increases. And when doing the third column, assume that the money supply is unchanged at the time its growth rate increases. This is further clarified in the diagram below.

Goods market—based on chapter 5 of my lecture notes

Let the total desired consumption spending of households be denoted C. According to the theory discussed in class, C _____ when Y increases, ______when T increases, and ______when R increases. Fill in the blanks using any or all of the following answers: increases, decreases, stays unchanged. Here T represents the government’s net tax revenue.

In the first column of the table below, please list three variables that affect net exports (NX or CA). (Please specify the symbols that represent the variable plus the descriptive name of the variable; for example: “P*, the foreign price level.”) In the second column, specify whether NX increases or decreases when the variable you listed in the first column increases.

When this variable increases … / NX…

The goods market is in equilibrium when

a. Y = C + I + G + exports

b. Y = C + I + G + exports – imports

c. Y = C + I + G + exports + imports

d. Ms = L(R) × P × Y.

Miscellaneous

YOU DEFINITELY NEED TO KNOW THE PREDICTION GRIDS IN CHAPTERS 9 AND 10 OF MY LECTURE NOTES. THESE ARE TABLES 9.1, 10.1, AND 10.2.

  1. Absolute Purchasing Power Parity is the assumption that
  1. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to express all prices in the same currency. Therefore, P = E × P*. This also implies that the real exchange rate is q = 1.
  2. The real exchange rate is constant, though not necessarily equal to 1.
  3. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to express all prices in the same currency. Therefore, the real exchange rate is constant, though not necessarily equal to 1.
  4. The domestic interest rate (R) is equal to the foreign interest rate (R*) plus the expected rate of appreciation of the foreign currency.
  1. Relative Purchasing Power Parity is the assumption that
  1. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to express all prices in the same currency. Therefore, P = E × P*. This also implies that the real exchange rate is q = 1.
  2. The real exchange rate is constant, though not necessarily equal to 1.
  3. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to express all prices in the same currency. Therefore, the real exchange rate is constant, though not necessarily equal to 1.
  4. The domestic interest rate (R) is equal to the foreign interest rate (R*) plus the expected rate of appreciation of the foreign currency.
  1. Under relative purchasing power parity,
  1. The expected rate of appreciation of the foreign currency is equal to the excess of the foreign inflation rate over the domestic inflation rate
  2. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency’s value is expected to appreciate by 2%
  3. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency’s value is expected to depreciate by 2%
  4. If the foreign interest rate is 7% and the domestic interest rate is 5%, the foreign currency’s value is expected to depreciate by 2%
  1. Under uncovered interest rate parity,
  1. The expected rate of appreciation of the foreign currency is equal to the excess of the foreign inflation rate over the domestic inflation rate
  2. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency’s value is expected to appreciate by 2%
  3. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency’s value is expected to depreciate by 2%
  4. If the foreign interest rate is 7% and the domestic interest rate is 5%, the foreign currency’s value is expected to depreciate by 2%
  1. Under relative purchasing power parity and fixed exchange rates, the expected rate of appreciation of the foreign currency is zero. Therefore,
  1. the foreign inflation rate equals the domestic inflation rate
  2. the foreign inflation rate equals the domestic inflation rate plus the domestic interest rate
  3. the foreign inflation rate is less than the domestic inflation rate
  4. the foreign inflation rate is unrelated to the domestic inflation rate
  1. Tariffs, which are taxes on imported goods and services, can raise output (Y) and net exports (NX)
  1. in both the long run and the short run, under fixed exchange rates but not under flexible exchange rates
  2. in neither the long run nor the short run
  3. in the short run but not in the long run, and under fixed exchange rates but not under flexible exchange rates
  4. in the long run but not in the short run
  5. in the short run but not in the long run, and under both flexible and fixed exchange rates
  1. A country can improve its net exports (NX)
  1. by implementing contractionary fiscal policy (G↓ and/ or T↑). This is effective in the short run and in the long run, under fixed exchange rates and under flexible exchange rates.
  2. by implementing expansionary fiscal policy (G↑ and/ or T↓). This is effective in the short run and in the long run, under fixed exchange rates and under flexible exchange rates.
  3. by implementing contractionary fiscal policy (G↓ and/ or T↑). This is effective only in the short run and only under flexible exchange rates.
  4. by implementing expansionary fiscal policy (G↑ and/ or T↓). This is effective only in the short run and only under flexible exchange rates.
  5. by implementing contractionary fiscal policy (G↓ and/ or T↑). This is effective only in the short run and only under fixed exchange rates.
  1. Expansionary monetary policy, which consists of an increase in money supply (M↑) under flexible exchange rates and devaluation (E↑) under fixed exchange rates, affects output (Y) and net exports (NX) in the short run as follows:
  1. Y↑ and NX↑
  2. Y↑ and NX↓
  3. Y↓ and NX↓
  4. Y↓ and NX↑
  1. Irrespective of the exchange rate system, expansionary fiscal policy (G↑ and/ or T↓) will cause output to increase (Y↑)
  1. In the long run, but not in the short run
  2. In both the long run and the short run
  3. In neither the long run nor the short run
  4. In the short run, but not in the long run
  1. Expansionary monetary policy (M↑ under flexible exchange rates and E↑ under fixed exchange rates) will cause output to increase (Y↑)
  1. In the long run, but not in the short run
  2. In both the long run and the short run
  3. In neither the long run nor the short run
  4. In the short run, but not in the long run

The real exchange rate in the long run