Suppose there is a financial crisis in the domestic money market. The rest of the world is not affected.

Assume flexible exchange rates. What are the consequences for the domestic economy?

a. There will be a recession. b. There will be a boom. c. Income won't change. d. No answer possible.
Suppose there is a financial crisis in the domestic capital market. The rest of the world is not affected. Assume flexible exchange rates. What are the consequences for the domestic economy?

a. There will be a recession. b. There will be a boom. c. Income won't change. d. No answer possible.
Suppose there is a global financial crisis that affects both the domestic capital market and the capital market in the rest of the world. Assume fixed exchange rates. What are the consequences for the domestic economy?

a. There will be a recession. b. There will be a boom. c. Income won't change. d. No answer possible.
Suppose there is a global financial crisis that affects both the domestic money market and the money market in the rest of the world. Assume flexible exchange rates. What are the consequences for the domestic economy?

a. There will be a recession. b. There will be a boom. c. Income won't change. d. No answer possible.

Suppose there is a financial crisis in the domestic money market. The rest of the world is not affected. Assume fixed exchange rates. What are the consequences for the domestic economy?

a. There will be a recession. b. There will be a boom. c. Income won't change. d. No answer possible.
Suppose there is a financial crisis that affects only the capital market in the rest of the world. The domestic capital market is not affected. Assume fixed exchange rates. What might be the reason that there is a domestic recession?

a. A strong elasticity of exports with respect to foreign income. b. A strong elasticity of imports with respect to domestic income. c. A strong elasticity of net exports with respect to the real exchange rate. d. The domestic economy is caught in a liquidity trap.
2) Theoretical implications of risk premia (12 points) Consider a small, open economy with fixed exchange rates. The economy is in its long-run equilibrium. The equilibrium of the goods market can be described by (1) Y = C(Y,T) + I(iC ) + G + EX(R,YW) - IM(R,Y) and the money market equilibrium by (2) M = L(r,Y) The equilibrium condition for the foreign exchange market is (3) i = iW In addition we have (4) iC = i+RPC (5) r = i-RPM where i denotes the interest rate in the money market and i C denotes the interest rate in the capital market. r denotes the return that households expect when they deposit their money at a bank. RP M and RPC are the risk premia charged in the money and the capital market, respectively. First-order derivatives are as postulated in Grtner and Jung (2011).

Substitute equations (3), (4) and (5) into (1) and (2) and compute the total differentials dY and dM. Which of the following equations describes dY? Note: Variables with subscripted letters denote partial derivatives (except RP M, RPC, iC). Hence, CY is the partial derivative of the consumption function with respect to income.

dY = CYdY + CT dT + Iic diw + dG + (EXR-IMR)dR + EXYwdYw dY = Y diw + Y dRPM + (EX-IM)dG dY = (CT-IMT )dY + CY dT + Iic (diw+dRPc) + dG + (EXR-IMR)dR + EXYwdYw dY = Y diw dY = (CY-IMY )dY + CT dT + Iic (diw+dRPc) + dG + (EXR-IMR)dR + EXYwdYw
Which of the following equations describes dM?

dM = M diW - dRPM + LYdY dM = Lr (diW-dRPM)+LYdY + (EXY - IMY)dY dM = Lr (diW-dRPM)+LYdY dM = Lr diW dM = dY

Which of the following variables are endogeneous in this setting?

R IM iW Y RPM C

M
Calculate an analytical expression that describes the consequences of an increase of the risk premium in the domestic capital market on income. Which of the following expressions corresponds to the result? Hint: One possible way to find the solution is the implicit function theorem that has already been discussed in the lecture (see the slides). A short description would be: Given a function f(x,y) = 0 that, possibly, cannot be solved for either x nor y, it holds that dy/dx = -fx/fy where, again, fx and fy are the partial derivatives of f with respect to x and y, respectively.

dY = dR>0 dY = IiC / (1-CY+IMY) - rRPM<0 dY/dRPC = IiC / (1-CY+IMY)<0 dY/dRPC = 0 dY/dRPM = RPM + IiC / (1-CY+IMY)<0 dY/dRPC = IiC / (1-CY+IMY)>0 dY = dR<0 dY = IiC / (1-CY+IMY)<0 dY/dRPC = - (Lr iWRPC) / (-Lr) > 0
You can check your analytical result with the help of the online applet An interactive primer on the macroeconomics of financial crises (www.eurmacro.unisg.ch/xercises/crisis.html). Use the default settings of the applet shown in step 5 and fix exchange rates. Now, you can observe what happens if you increase the risk premium on the domestic capital market. Precisely, determine domestic equilibrium income if households expect that one of a hundred firms will default on their debt. Answer:

3) DAD-SAS model (13 points) Consider an economy with fixed exchange rates, which can be described by the following DAD and SAS curves: = w - b(Y-Y-1) + G + Yw - fiw = e + (Y-Y*) The economy is in its long run equilibrium in period 0. Inflation expectations are formed adaptively. Note: As mentioned in the introduction of this test, please round your results as usual to 2 decimals. Assume the following values for exogenous variables and coefficients:

w=10 b = 0.038 = 1.3 = 0.1 f = 2.1 G = 50 Yw= 200 iw= 5 = 0.063 Y*=197 What is the rate of inflation in period 0? Answer:
10

In period 1 the world interest rate iw increases by 2.6 units (and remains there for all future periods). What is the level of income in period 1? Answer:
142.94

What is the rate of inflation in period 1? Answer:

6.59

What is the level of income in period 2. Note: If you need results from previous questions for your calculations, make sure you round them to 2 decimals. Answer: 4) 2 Country Solow Model (13 points) Go to the eurmacro site and open the 2-country Solow growth model (http://www.eurmacro.unisg.ch/Tutor/solow2country.html). Set the labor supply L to 200 in country A and to 210 in country B. Country A saves 40% of its income whereas country B saves only 20% of its income. Country A has low human capital (0.5). Country B has twice as much.

Part I: Suppose capital is completely immobile

181 283

Income, both GDP and GNP, in country A is is .

larger than

. Income in country B is

even though the capital stock in A

the capital stock in B. This is due to

the higher level of human capital in B

Part II: Now, look at what happens with the steady state if you remove the capital controls
A to B

Capital flows from

which means that, in autarky, marginal product of capital in A had

been flows.

lower

than in B. Hint: Use the check boxes Show investment flows and Show income

The capital stock per capita in both countries is now

different due to different levels of human capital

The net return on capital in both countries is now

consumption

In both diagrams, the vertical distance between the blue dot and the green dot denotes

Net exports from B to A in the new steady state are

loose

Compared to the autarky state, capital owners in A workers is

gain

income and

income. In country B the situation .

the opposite

Part III: Transition dynamics The previous questions looked at the new steady state. As you know, this new steady state is not reached immediately after the capital markets have opened. Use the Show dynamic adjustment button to observe the transition from the old to the new steady state. In the period when the capital market opened (that is the second column in both diagrams), domestic capital income in A amounts to
47

and entire capital income in A amounts to

82