Econ 181 Midterm (110 Points Total)

Econ 181 Midterm (110 points total)

Multiple choice (3 points each, 15 points total)

1. In an open economy, private saving, Sp, is equal to

1. I - CA + (G - T).
2. I + CA - (G - T).
3. I + CA + (G - T).
4. I - CA - (G - T).
5. I + CA + (G + T).

Answer: C

2. When a country’s currency depreciates,

A.  foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are more expensive.

B.  foreigners find that its exports are more expensive, and domestic residents find that imports from abroad are cheaper.

C.  foreigners find that its exports are cheaper; however, domestic residents are not affected.

D.  foreigners are not affected, but domestic residents find that imports from abroad are more expensive.

E.  None of the above.

Answer: E

3. Which one of the following statements is the most accurate?

A.  The dollar rate of return on euro deposits is the euro interest rate plus the rate of depreciation of the dollar against the euro.

B.  The dollar rate of return on euro deposits is approximately the euro interest rate minus the rate of depreciation of the dollar against the euro.

C.  The dollar rate of return on euro deposits is the euro interest rate minus the rate of depreciation of the dollar against the euro.

D.  The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of appreciation of the dollar against the euro.

E.  The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro.

Answer: E

4. Given PUS and YUS,

A.  an increase in the European money supply causes the euro to appreciate against the dollar, but it does not disturb the U.S. money market equilibrium.

B.  an increase in the European money supply causes the euro to appreciate against the dollar, and it creates excess demand for dollars in the U.S. money market.

C.  an increase in the European money supply causes the euro to depreciate against the dollar, and it creates excess demand for dollars in the U.S. money market.

D.  an increase in the European money supply causes the euro to depreciate against the dollar, but it does not disturb the U.S. money market equilibrium.

E.  None of the above statements is true.

Answer: D

5. Under PPP,

A.  a rise in a country’s expected inflation rate will eventually cause a more-than proportional rise in the interest rate that depositors of its currency offer in order to accommodate for the higher inflation.

B.  a fall in a country’s expected inflation rate will eventually cause an equal rise in the interest rate that depositors of its currency offer.

C.  a rise in a country’s expected inflation rate will eventually cause an equal rise in the interest rate that depositors of its currency offer.

D.  a rise in a country’s expected inflation rate will eventually cause a less than proportional rise in the interest rate that depositors of its currency offer to accommodate the rise in expected inflation.

E.  None of the above statements is true.

Answer: C

Short answer (5 points each, 15 points total)

1. Discuss the effects of a rise in the interest rate paid by euro deposits on the exchange rate, illustrating with a simple diagram.

Answer: For a given U.S. interest rate and a given expectation with regard to the future exchange rate, a rise in the interest rate paid by euro deposits causes the dollar to depreciate.

2. What are the main factors determining the aggregate money demand?

Answer: Three main factors: interest rate, the price level, and real national income. A rise in the interest rate causes each individual in the economy to reduce her demand for money. If the price level rises, individual households and firms will spend more money than before. When real national income (GNP) rises, the demand for money will rise.

3. What will be the effects of an increase in real national income on the interest rate?

Answer: An increase in real national income will increase the interest rate. If investment depends only on interest rate, this will cause investment to go down. The increases interest rate will cause an appreciation of the dollar.

Medium Answer (10 points each, 50 points total) Provide formulas where appropriate.

1. Using a figure describing both the U.S. money market and the foreign exchange market, analyze the effects of a temporary increase in the European money supply on the dollar/euro exchange rate. Provide a graph.

Answer: An increase in the European money supply will reduce the interest rate on the euro and thus will cause the schedule of the expected euro return expressed in dollars to shift down, causing a reduction in the dollar/euro exchange rate, that is, an appreciation of the U.S. Dollar. The euro depreciates against the dollar. The U.S. money demand and money supply are not going to be affected, and thus the interest rate in the U.S. will remain the same.

2. Explain the Law of One Price. Give an example.

Answer: The law of one price states that in competitive markets free of transportation costs and trade barriers, identical goods sold in different countries must sell for the same price when expressed in terms of the same currency.

PiUS = (E$/E) x (PiE) for good i.

E$/E = PiUS/PiUK

If, for example, the price of the same sweater was cheaper in London than in New York, U.S. importers and British exporters would have an incentive to buy sweaters in London and ship them to New York, pushing the London price up and the New York price down, until both were equal.

3. What is the Fisher Effect? Provide an example.

Answer: All else equal, a rise in a country’s expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer. Similarly, a fall in the expected inflation rate will eventually cause a fall in the interest rate.

Ex: If the expected U.S. inflation were to rise permanently from Π to (Π + ΔΠ), current dollar interest rates R$ would eventually catch up to the higher inflation, rising by a value ΔR$ = ΔΠ in accordance with the Monetary Approach that in the long run purely monetary developments should have no effect on an economy’s relative prices since the real rate of return on dollar assets would remain unchanged.

4. Discuss the effects of government deficits on the current account.

Answer: See pages 306 – 307 A hard and difficult issue. During the Reagan administration, the creation of twin deficits, whereby slashing taxes, government deficits increased, which was accompanied with increased current account deficits.

Using the identity CA = Private Saving - I - (G – T), one can see that if private savings and I are constants, an increase in the deficit, namely an increase in (G – T), necessarily increases the CA deficits by the same magnitude.

However, government budget deficit may change both private savings and investment, thus avoiding a creation of the twin deficits. An example is the European countries reducing their budget deficits just prior to the introduction of the euro in January 1999. Now, under the “twin deficits: theory,” one would have expected the EU’s current account surpluses to increase. This has never happened. The main reason was sharp reduction in private saving rates.

A good answer should discuss Ricardian equivalence, which argues that when the government cut taxes and raises its deficit, consumers anticipate that they will face higher taxes later to pay for the resulting government debt. In anticipation, they raise their own private saving to offset the fall in government saving. In addition, one should mention wealth effect in anticipation of one Europe, assets prices increased, lowering private saving rates.

5. Assume the U.S. interest rate is 10 percent, and the interest rate on euro deposits is 5 percent.

For the following exchange rates, find the (one-year) forward exchange rates. Show work!

Answer: Using the covered interest rate parity will yield the second column in the table:

F$/E = (R$ - RE) E$/E + E$/E

Figures (15 points each, 30 points total)

Use the following graph.

1. To answer the following question, please refer to the figure above. Concentrating only at the lower right quadrant, discuss the effects of a change in U.S. expected inflation.

Answer: The lower right quadrant shows the equilibrium in the U.S. Money Market, where

R1$ = M1US/P1US.

A given interest rate R1$ corresponds with a given U.S. real money supply, M1US/P1US

Consider a rise of ΔΠ in the future rate of U.S. money supply growth (i.e. an increase in the expected rate of inflation).

The Key Point: The rise in expected future inflation generates expectations of more rapid currency depreciation in the future.

Under PPP the dollar now depreciates at a rate of Π + ΔΠ.

Interest parity therefore requires the dollar interest rate to rise where

R2$ = R1$ + ΔΠ. (Point 2 in the figure.)

Note: R$ – RE= ΠeUS – ΠeE

This relation shows a change in the U.S. interest rate due to an increase in expected U.S. inflation has no effect on the euro interest rate.

The rise in the interest rate from R1$ to R2$ creates a momentary excess supply of real U.S. money balances at the prevailing price level P1. However, since under this

Monetary Approach, prices are assumed to be flexible, prices will immediately adjust from P1 to P2, thus causing the following two effects: One: Reducing real money supply and, Two: Bringing the U.S. money market back into equilibrium.

2. To answer the following question, please refer to the figure above. Concentrating only at the lower left quadrant, discuss the relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E.

Answer: The lower left quadrant in the figure described the Purchasing Power Parity (PPP) relationship. The relationship between the U.S. real money supply and the dollar/euro exchange rate, E$/E is negative.

E$/E is equal to the price level ratio, PUS/ PE.

In this derivation of the relationship, the following variables are assumed constants: M1US, RE, and PE.

So, E$/E = M1US/PUS

The increase in PUS leads to a positive increase in E$/E.

P1US will shift to P2US

Thus, the purchasing power of the dollar decreases due to the increase in the price level.

E1$/E will shift to E2$/E.

That is, the dollar depreciates due to PPP.