ECON 204 F01

INTERMEDIATE MACROECONOMIC THEORY

Fall, 2006
ASSIGNMENT 3

Instructions: The assignment is due by 3 pm on Nov 27 in the assignment box for this
course located in the hall beside room BEC 360. Late assignments will not be marked. If
you cannot turn in an assignment due to extenuating circumstances, you must contact the
instructor as soon as possible and present documentation. Assignments will be marked on
the quality of the response to the questions, clarity of exposition, and quality of
presentation.

Answer all questions. (Total 40 marks)

Q1: Textbook p240 Q3. (10 marks)

Answer:
a. When Leverett’s exports become less popular, its domestic saving Y-C-G does not
change. This is because we assume that Y is determined by the amount of capital and
labor, consumption depends only on disposable income, and government spending is a
fixed exogenous variable. Investment also does not change, since investment depends on
the interest rate, and Leverett is a small open economy that takes the world interest rate as
given. Because neither saving nor investment changes, net exports, which equal S-I, do
not change either. This is shown in the following figure as the unmoving S-I curve.
e S-I

e1 NX1(e)
e2
NX2(e)
NX
NX1=NX2
Even though Leverett’s exports are less popular, its trade balance has remained the same.
The reason for this is that the depreciated currency provides a stimulus to net exports,
which overcomes the unpopularity of its exports by marking them cheaper.

b. Leverett’s currency now buys less foreign currency, so traveling abroad is more
expensive. This is an example of the fact that imports (including foreign travel) have
become more expensive – as required to keep net exports unchanged in the face of
decreases demand for exports.

c. If the government reduces taxes, then disposable income and consumption rise. Hence,
saving falls so that net exports also fall. This fall in net exports puts upward pressure on
the exchange rate that offsets the decreased world demand. Investment and the interest
rate would be unaffected by this policy since Leverett takes the world interest rate as
given.
Q2: Textbook p241 Q8. (10 marks)
Answer:
a. The fisher equation says that
i = r+e
where i = the nominal interest rate; r = the real interest rate (same in both countries);
e=the expected inflation rate. Plugging in the values given in the question for the
nominal interest rates for each country, we find:
12 = r + cane, 8 = r + use. This implies that cane - use = 4. Because we know that the
real interest rate i is the same in both countries, we conclude that expected inflation in
Canada is four percentage points higher than in the United States.

b. Consider US as the home country. As in the text, we can express the nominal exchange
rate as
e =  * (Pcan/Pus),
where  = real exchange rate, Pcan = the price level in Canada, Pus = the price level in US.
The change in the nominal exchange rate can be written as:
% change in e = % change in  + cane - use.
We know that if purchasing-power parity holds, than a dollar mush have the same
purchasing power in every country. This implies that the percent change in the real
exchange rate  is zero because purchasing-power parity implies that the real exchange
rate is fixed. Thus, changes in the nominal exchange rate result from differences in the
inflation rates in the US and Canada. In equation form this says
% change in e = cane - use.
Because economic agents know that purchasing-power parity holds, they expect this
relationship to hold. In other words, the expected change in the nominal exchange rate
equals the expected inflation rate in Canada minus the expected inflation rate in the US.
That is,
Expected % change in e = cane - use.
Therefore, the expected change in the nominal exchange rate e is 4 percent. That is,
Canadian dollar will depreciate by 4%.

c. The problem with your friend’s scheme is that it does not take into account the change
in the nominal exchange rate e between the U.S. and Canadian dollars. Given that the real
interest rate is fixed and identical in the US and Canada, and given purchasing-power
parity, we know that the difference in nominal interest rates accounts for the expected
change in the nominal exchange rate between US and Canadian dollars. In this example,
the Canadian nominal interest rate is 12 percent, while the US nominal interest rate is 8
percent. We conclude from this that the expected change in the nominal exchange rate if 4
percent. Therefore,
e this year =1C$/US$
e next year=1.04C$/US$.
Assume that your friend borrows 1 US dollar from an American bank at 8 percent,
exchange it for 1 Canadian dollar, and puts it in a Canadian bank. At the end of the year
your friend will have $1.12 in Canadian dollars. But to repay the American bank, the
Canadian dollars must be converted back into US dollars. The $1.12 (Canadian) becomes
$1.08 (American), which is the amount owed to the US bank. So in the end, your friend
breaks even. In fact after paying for transaction casts, your friend loses money.

Q3: Textbook p365 Q6. (Just assume the economy has a floating exchange rate system.)
(10 marks)
Answer:
a. A higher exchange rate makes foreign goods cheaper. To the extent that people
consume foreign goods (a fraction 1-lumba), this lowers the price level P that is relevant
for the money market. This lower price level increases the supply of real balances M/P.
To keep the money market in equilibrium, we require income to rise to increase money
demand as well. Hence, the LM curve is upward sloping.

b. In the standard Mundell-Fleming model, expansionary fiscal policy has no effect on

output under floating exchange rates. As shown in the following figure, this is no longer
true here. A cut in taxes or an increase in government spending shifts the IS curve to the
right, from IS1 to IS2. Since the LN curve is upward sloping, the result is an increase in
output.

e LM

e1 B

e2 A
IS2

IS1

Y1 Y2 Y

c. An increase in the country risk premium drives up the domestic interest rate and
discourages the domestic investment. In the Y-e diagram, this effect implies a shifting
of the IS curve. On the other hand, a higher domestic interest rate decreases the
money demand at home. If the money supply has no adjustment, this leads to a
shifting of the LM curve.
LM3
e LM1
A LM2
e1
C
B IS1
e2
IS2 Y
Y3 Y1 Y2
If the economy has a floating exchange rate system, equilibrium will move from A to B:
domestic currency depreciates. However, change of output is ambiguous since it depends
on the responds from the goods market (IS curve) and the responds from the money
market (LM curve). In my diagram, output increases.

If the economy has a fixed exchange rate system, LM curve will shift back until the
market exchange rate goes back to the initial level. This causes the output decreases to
Y3.

Note: I believe most of the students will only discuss the floating exchange rate case, so
the LM curve moves out once and won’t move back; the economy moves from A to B.

Q4: Assume that the LM curve for a small open economy with a floating exchange rate is
given by Y=200r-200+2(MS/P), where MS=100. while the IS curve is Y=400+3G-
2T+NX-200r. Here NX=800-100e, G=100 and T=100. The international interest rate, r*,
is 2.5 percent. (Please use 2.5 to solve questions.)

a. Find the equilibrium value of Y in this economy if P=1.0.

Answer: Y=500. From the LM curve, Y=200(2.5)-200+2(100/1)=500.
b. Given this value of Y, what must be the equilibrium value of e and NX?
Answer: NX=500. From IS curve, 500=400+100+NX-500, or NX=500.
e=3. From NX equation, 500=800-100e, or 100e=300, or e=3.
c. Assuming e is equal to the number in part b), derive the AD function.
Answer: From the LM: Y=200r-200+200/P, we get r=Y/200+1-1/P. Substitute this
expression of the interest rate into the IS curve:
Y=400+300-200+800-100e-200(Y/200+1-1/P).
Note: If students use  , the real exchange rate, in the above AD function, it’s fine.
Substitute the e=3 into the above equation, we can drive the AD function: Y=400+100/P.
Note: If students didn’t substitute e=3 into the AD function but stopped at the last step, it
doesn’t matter.