202 PS5 with answers.pdf | Exchange Rate

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METU, Department of Economics ECON 202 Section 1 2016-17 Spring Instructor: Hasan Cömert T.A.: Güney Düzçay PROBLEM SET 5 & ANSWERS A. PROBLEMS 1- Using the information in the 19th chapter, label each of the following statements true, false or uncertain. Explain briefly. a. The national income identity implies that budget deficits cause current account deficits. b. Opening the economy to trade tends to increase the multiplier because an
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  1 METU, Department of Economics ECON 202 Section 1 2016-17 Spring Instructor: Hasan Cömert  T.A.: Güney   Düzçay   PROBLEM SET 5 & ANSWERS A.   PROBLEMS 1-   Using the information in the 19th chapter, label each of the following statements true, false or uncertain. Explain briefly. a. The national income identity implies that budget deficits cause current account deficits. b. Opening the economy to trade tends to increase the multiplier because an increase in expenditure leads to more exports. c. If the trade deficit is equal to zero, then the domestic demand for goods and the demand for domestic goods are equal. d. A real depreciation leads to an immediate improvement in the trade balance. Answer: a.   False. CA = S + (T  –   G)  –   I. Budget deficit (negative T  –   G) may be offset by large positive difference of S and I so that there would be current account surplus. b.   False. In fact, any autonomous spending multiplier will be reduced in an open economy case. c.   True. If NX = 0, demand for domestic goods: C+I+G+NX(e) = C+I+G : domestic demand for goods. d.   False. Indeed, there is no immediate improvement and it takes time. 2-   Answer the following questions: a. Suppose there is an increase in foreign output. Show the effect on the domestic economy. What is the effect on domestic output? On domestic net exports? b. If the interest rate remains constant, what will happen to domestic investment? If taxes are fixed, what will happen to the domestic budget deficit? c. Using equation (19.5), what must happen to private saving? Explain. d. Foreign output does not appear in equation (19.5), yet it evidently affects net exports. Explain how this is possible.  2 Answer: 3-   Suppose an economy is experiencing a large trade deficit. Government officials now decide to eliminate this deficit. Against this background, answer the following questions (explain using diagrams): a.   What type of (domestic) fiscal policy (expansionary or contractionary) could be  pursued? What effect would this policy have on (domestic) output? b.   What type of exchange rate policy (nominal appreciation or nominal depreciation) could be pursued to eliminate the trade deficit? What effect would this policy have on (domestic output)? c.   What type of exchange rate  –   fiscal policy combination could be implemented to eliminate the trade deficit? d.   Suppose domestic policy makers can influence foreign fiscal policy. What type of foreign policy (expansionary or contractionary) could be implemented to eliminate the trade deficit? What effect will this have on domestic and foreign output? Answer : See page 411-412 of your textbook. 4-   Consider an open economy characterized by the equations below.  =  0  + 1 ( −)    =  0  + 1     =  1      =  1  ∗  The parameters m 1  and x 1  are the propensities to import and export. Assume that the real exchange rate is fixed at a value of 1 and treat foreign income, Y*, as fixed. Also assume that  3 taxes are fixed and that government purchases are exogenous (i.e., decided by the government). We explore the effectiveness of changes in G under alternative assumptions about the propensity to import. a.   Write the equilibrium condition in the market for domestic goods and solve for Y. b.   Suppose government purchases increase by one unit. What is the effect on output? (Assume that 0 < m 1 < c 1 +d 1 < 1. Explain why.) c.   How do net exports change when government purchases increase by one unit?  Now consider the two economies, one with m 1 =0.5 and the other with m 1 =0.1. Each economy is characterized by (c 1 + d 1 ) = 0.6. d.   Suppose one of the economies is much larger than the other. Which economy do you expect to have the larger value of m 1 ? Explain. e.   Calculate your answers to parts (b) and (c) for each economy by substituting the appropriate parameter values. f.   In which economy will fiscal policy have a larger effect on output? In which economy will fiscal policy have a larger effect on net exports? Answer:  4 B.   DISCUSSION TOPICS 1-   In Chapter 19 of your textbook, it is shown that exchange rate depreciation leads to  both higher output and less trade deficit (or more surplus) with no mention of any  possible disadvantage . So, why don’t countries consistently try to depreciate their currencies? Can you give an example of mechanism that depreciation would imply very disastrous conditions for the domestic economy. Answer:  Depreciation of a currency may be very harmful for a country considering its effects on inflation. Depreciation of a currency implies that the prices of imported goods in terms of domestic currency are increasing. If some of those imported goods, such as oil or natural gas, are essential inputs for domestic production, then the prices of all domestic products will increase due to increased costs. This would create an inflationary environment, which is bad for the economy as a whole. See also the answer for the next question. 2-   The following quote is from a paper written by the former governor of Central Bank of Republic of Turkey, Erdem Başçı:   “  Apart from its conventional impact on aggregate demand via foreign trade, the exchange rate has the fastest channel of transmission owing to its effects on key variables such as expectations, the risk premium, firms’ balance sheets, production costs, and prices in Turkey. The existence of supply side effects  –   operating mainly through cost and balance sheet channels  –   may give rise to non-conventional relationships. A historical glance at the relationship between the real exchange rate and business cycles in Turkey clearly shows that appreciation periods coincide with solid expansion phases whereas strong depreciation episodes are associated with recessions. ”   How does Başçı’s argument relate to “Marshall - Lerner condition” that you have seen in class and also in your textbook? Can you think of any economic reason leading to such non-conventional results especially in the context of a developing country such as Turkey? Answer: The above argument is compatible with Marshall- Lerner condition since Başçı admits the conventional impact of exchange rate changes on aggregate demand via foreign trade. However, Başçı also argues that there are other channels at work, through which currency depreciation can decrease output rather than increase. In the textbook it is shown that currency depreciation leads to higher output through the shift of the ZZ curve (as a result of the increase in net exports). However, in describing the goods market equilibrium, the textbook uses some assumptions. In particular, consumption and investment are treated to have no direct relation with exchange rate so that any exchange rate change does not have an impact on domestic demand for goods (DD curve does not shift) and the only impact is via net exports. But, if there is such relation through various channels as
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