International Economics Problem Set 3

International EconomicsProblem Set 3Upload to NYU Classes by 5pm, Monday, Nov.21stNovember 2016 1 IS/LM The following functions and values characterize the goods market, the moneymarket, and the foreign exchange market in the home country.Goods MarketC=100+.9(Y–T)I=350–1,750iG=1000T=1000TB = 750(1 – Ee/E) – .15(Y – 500)Money MarketMd/P = L(Y, i) = 0.4Y – 6,000iM = 1,680P= 3?e = 0Foreign exchange marketEe = 4i? =.05a. Using the uncovered interest parity condition, solve for the exchange rate(E) as a function of the interest rate (i).b. Derive equations for IS and LM. For each, express output (Y) as a functionof the interest rate (i). Find the equilibrium values of the interest rate (i) andoutput (Y).c. Calculate the levels of consumption (C), investment (I), the trade balance(TB), and the exchange rate (E), at the equilibrium. The government needs toincrease spending temporarily, by 400, and it decides to increase taxes by thesame amount.d. Find the new equilibrium levels of the interest rate (i) and output (Y).1 e. Calculate the new levels of consumption (C), investment (I), the tradebalance (TB), and the exchange rate (E), at the equilibrium.f. Using the IS-LM and FX market graphs, illustrate how this temporarybalanced-budget increase in G affects the levels of i, Y, and E. Use the valuesyou calculated in parts b-c and d-e to label your graphs. 1.1 Monetary Stabilization Now, suppose that monetary policy is used to stabilize output. (Monetary policyis used to restore the level of output in part c, following the balanced-budgetincrease in government spending in part e.g. Find the level of the money supply that will result in the same level ofoutput as before the balanced-budget increase in G.h. Calculate the levels of the interest rate, the trade balance, and the exchange rate with this monetary policy.i. Using the IS-LM and FX market graphs, illustrate how the combination ofthe balanced-budget increase in G and the monetary stabilization policy affectsthe levels of i and E. Label your graphs with the values you calculated in partsd and h. Suppose instead that the country has a fixed exchange rate (E = 4).The central bank defends the peg (E = 4), and it maintains convertibility.j. Explain the combined effects of the temporary balanced-budget increasein G and central bank actions to defend the peg. k. Calculate the levels ofoutput, the exchange rate, and the trade balance resulting from a defense of thepeg.l. Using the IS-LM and FX market graphs, illustrate how the combinationof the balanced-budget increase in G and defense of the peg affects the levels ofY and E. Label your graphs with the values you calculated in part k. 2 Combating a Recession In late 2007, the US slipped into a serious recession, due to falling home prices(falling wealth), investor pessimism, and reduced exports. Reinforcing theseshocks were a large negative money shock (due to a sharp drop in the M1multiplier), and a credit crunch (impaired lending to firms, which negativelyaffected production).a. Use the IS-LM-FX diagrams to analyze the impacts of these negativeshocks. Indicate the impacts on the following variables: Y, i, E, C, I, TB (inthe absence of any government policies). 3 Convergence This problem uses the production function and MPK diagrams to examineTurkey and the EU. Assume that Turkey and the EU have production functions of the form q = Ak 1/3 , where q is output per worker, k is capital per 2 worker, and productivity (A) is potentially different across the two “countries.”The graphs in this problem are qualitative.a. Draw a production function graph and an M P K graph for the EU.Put the M P K diagram directly below the production function graph, so theirhorizontal axes (k) are aligned.Add Turkey’s production function and MPK graph, assuming Turkey’s productivity level (A) is less than the EU level.Designate the world real interest rate (just choose it arbitrarily). AssumingMPK in the EU equals the world real interest rate (r? ), due to free capital mobility between the EU and the rest of the world, label kEU and qEU . AssumingTurkey’s MPK exceeds MPK in the EU (because Turkey does not have freecapital mobility), label M P KT 1 , kT 1 , and qT 1 .b. Now assume capital begins to flow freely between the EU and Turkey(and the rest of the world). As a result, M P KT converges to M P KEU (which,as in part a, equals the world real interest rate). Show the consequences of thisfor kT 2 and qT 2 (label these points). Does per capita output in Turkey partiallyor completely converge to that of the EU? Explain.c. Consider an alternative explanation for the initial gap in MPK’s betweenthe EU and Turkey. Suppose the gap is a risk premium due to investor concernabout the rule of law and macroeconomic policies affecting inflation. In thiscase, will capital mobility result in any convergence of Turkey’s per capita tothat of the EU? 4 Exchange Rate Regimes Consider two countries that share a border (North and South). North is alarge, high-income economy, with well-developed and technologically-advancedagricultural, manufacturing, and services sectors. North produces a significantamount of energy (including oil) but is an oil importer. North has been runninga current-account deficit for years. North’s real growth rate has been about2.5% to 3% for the past several years. Its inflation rate has been about 3%.Consider the following alternative scenarios. Each gives additional detailsabout South’s economic history and economic circumstances, and asks questionsabout South’s choice of exchange rate regime.a. South is a medium-sized, poor country. Its economy, and its manufacturing sector in particular, is much smaller, less productive, and less technologicallyadvanced than that of North. There is not much overlap between South’s output and North’s output. A big percentage of South’s GDP derives from copperand silver, whose prices are fairly volatile. South exports agricultural goods,copper, and silver. North buys some of South’s exports, but not a large share;South exports to a range of countries. South has had only negligible growth inrecent years.• What exchange rate regime should South adopt with respect to North,and why? 3 • Over several years, South’s manufacturing sector grows. Most of the fundsfor the growth of South’s manufacturing sector were borrowed from North.Firms from North put assembly plants and production facilities in South.Those goods are mostly exported to North. South imports manufacturedgoods and agricultural goods from North. South’s GDP growth rate picksup a bit. Do these developments change the best exchange rate regime forSouth? Explain.b. South is a middle-income developing country with a fairly large industrialsector. However, its industrial sector is much less productive than that of North.The entire economy of South is less productive. As a result, growth has beenslow.South’s manufacturing and agricultural sectors have significant overlap withNorth’s (i.e., South and North produce many of the same goods). North andSouth also engage in a lot of trade, in other goods.South’s government has run large budget deficits for years, as it has undertaken large amounts of spending on social programs and government-supportedindustrialization. South has sold considerable amounts of debt abroad, denominated in North’s currency. South also has sold a lot of debt domestically(denominated in South’s currency). In addition, South has relied heavily onseigniorage. As a result, inflation has been high, reaching hyperinflation severaltimes.At present, South’s inflation rate is accelerating, and the interest rate Southhas to pay to roll over its external debt is rising. South’s GDP growth rate iszero and South is in danger of slipping into a recession.• Explain why a country in South’s situation is likely to experience anotherhyperinflation.• South cannot reduce its government budget deficit. Given this, how shouldit finance its government budget deficit? Explain why. What exchangerate regime should it adopt? Explain why.• South wants to reduce its inflation rate permanently. What reforms andpolicies should South adopt, and why?• Suppose South adopts a fixed exchange rate with North. However, it cannot reduce its government budget deficit. What will happen as a result?Explain. 4

Order Solution Now

Similar Posts