Short Questions -

1. [T/F] Liquidity trap occur because the Opportunity cost of holding money is high.

2. [T/F] Pricing-to-market behavior is one reason for the J-curve effect.

3. [T/F] Multi-level distribution channels tend to make the depreciation of home currency more effective in improving trade balance.

4. Summarize the policy trilemma within 15 lines.

Questions -

I. IS-LM-FX model: Initial LR Eq'm

Q1-Q3 are based on the initial [Situation 1] below:

Situation 1 -

-The Home country is currently in its LR eq'm with: P =1, M₁^S = 1, G₁ = T₁ = 0, Y₁ = Y_potential

-Foreign variables: i* = 2(%), P* =1

-Assume that the IS curve is a straight line, and that its slope is preserved.

-C = C^- + MPC x (Y - T), MPC = 0.75

-Investment depends negatively on i.

-TB = -0.25 x Y + 0.5 x (EP*/P)

-Money demand: M^D = P x (Y - i)

-The initial IS curve labelled IS₁ is shown in the handout.

-In the LR:

i) PPP holds, and

ii) the expected ER is equal to the spot ER.

Q1. Given the initial values of P = 1 and M₁^S = 1, find the equation of the initial LM₁ curve.

(a) i = Y-1

(b) i = Y+1

(c) i = 2

(d) Y=3

Q2. Using the initial IS₁ curve in the handout and the LM₁ curve obtained in Q1, find the values of (Y, i) in the initial eq'm. [Let us call this "Equilibrium 1".]

(a) (3, 2)

(b) (2, 1)

(C) (3, 3)

(d) (2, 3)

Q3. Given the "Equilibrium 1", find the values of (i, E, E^e) in the corresponding initial eq'm in the FX market. [We also call this "Equilibrium 1".]

(a) (2, 1, 1)

(b) (1, 2, 2)

(c) (2, 2, 2)

(d) (1, 1, 1)

II. IS-LM-FX model: Floating ERs

Q4-Q10 are based on [Situation 2] below.

Situation 2 -

-The home currency is freely floating.

-The home country has been in the initial LR eq'm corresponding to [Situation 1].

-Today, the Home central bank TEMPORARILY increases money supply from M₁^S = 1 to M₂^S = 2.

-People know the increase in M^s is temporary.

-The new SR eq'm is called "Equilibrium 2."

Find the values of (Y, i, E, Real ER) in Equilibrium 2. [TIP: You can find them by moving curves on the handout. Figure out "how much will the LM curve more horizontally?" to begin with.}

Q4. Y

(a) 2.5

(b) 3

(c) 3.5

(d) 4

Q5. i

(a) 0.5

(b) 1

(c) 1.5

(d) 2

Q6. E

(a) 0.5

(b) 1

(c) 1.5

(d) 2

Q7. RER

(a) 0.5

(b) 1

(c) 1.5

(d) 2

[increase, decrease, invariant, or uncertain] Explain how the following variables change as the economy moves from Equilibrium 1 to Equilibrium 2.

Q8. C

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q9. I

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q10. TB

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q11-Q18 are based on the [situation 3] below:

Situation 3 -

-The home currency is freely floating.

-The home country has been in the long-run eq'm corresponding to [Situation 1].

-Today, the home gov't TEMPORARILY increases its purchases of domestic goods from G₁ = 0 to G₂ = 1.

-People know that the increase in G is temporary.

The new SR eq'm is called "Equilibrium 3".

Q11. By how much does the IS curve shift out?

(a) 1

(b) 2

(c) 3

(d) 4

 Find the values of (Y, i, E, Real ER) in Equilibrium 3.

Q12. Y  

(a) 2.5  

(b) 3

(c) 3.5

(d) 4

Q13. I

(a) 1.5  

(b) 2

(c) 2.5

(d) 3

Q14. E

(a) 0.5  

(b) 1      

(c) 1.5

(d) 2

Q15. RER

(a) 0.5  

(b) 1

(c) 1.5

(d) 2

[increase, decrease, invariant, or uncertain] Find the direction of changes in the following variables as the economy moves from Equilibrium 1 to Equilibrium 3.

Q16. C

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q17. I

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q18. TB

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q19-Q24 are based on the [Situation 4] below:

Situation 4 -

-The home currently is freely floating.

-The Home country has been in the LR eq'm corresponding to [Situation 1].

-Today, the Home central bank PERMANENTLY increases money supply from M₁^S = 1 to M₂^S = 2.

-People know that the increase in M is permanent.

-The new SR eq'm is called "Equilibrium 4."

Q19. What is the expected ER in Situation 4?

Q20. Regarding your answer to Q19, which of the IS and LM curves will shift, and in or out?

Suppose the magnitude of the shift in Q20 is 0.5. Find the values of (Y, I, E) in equilibrium 4.

Q21. Y

(a) 3.5

(b) 3.75 

(c) 4

(d) 4.25

Q22. i

(a) 1.5

(b) 1.75

(c) 2

(d) 2.25

Q23. E

(a) 4/3

(b) 8/3

(c) 12/3

(d) 16/3

Q24. Based on your reasoning in Q19-Q23, plot the movement in E over time. Be sure to mark key numbers.

III. IS-LM-FX model: Fixed ERS

Q25-Q31 are based on the Situation 5 below:

Situation 5 -

-The home currency is pegged to the foreign currency

-The home country has been in the LR eq'm corresponding to Situation 1.

-Today, the Home gov't TEMPORARILY increases in purchases of domestic goods from G₁ = 0 to G₂ = 1.

-People understand the increase in G is temporary.

-The new SR eq'm is called "Equilibrium 5."

Q25. In response to the increase in G, what should the home central bank do?

(a) sell foreign currency

(b) decrease M supply

(c) prevent the home currency from depreciation

(d) none of a) - c) above.

Find the values of (Y, i, M^S) in Equilibrium 5.

Q26. Y

(a) 3.5

(b) 4

(c) 4.5

(d) 5

Q27. i

(a) 1.5

(b) 2

(c) 2.5

(d) 3

Q28. M^S

(a) 0.5

(b) 1.5

(c) 2

(d) 3

[increase, decrease, invariant, or uncertain] Find the direction of changes in the following variables as the economy moves from Equilibrium 1 to Equilibrium 5.

Q29. C

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q30. I

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q31. TB

(a) inc

(b) dec

(c) invar.

(d) uncert.

Q32-Q35 are based on the [Situation 6] below:

Situation 6 -

-The home currency is pegged to the foreign currency

-The home country has been in the LR eq'm corresponding to [Situation 1].

-Today, the Home central bank TEMPORARILY increases money supply from M₁^S = 1 to M₂^S = 2.

-People know the increase in M Is temporary.

-The new SR eq'm under fixed ER is called "Equilibrium 6."

Find the values of (Y, i, E) in Equilibrium 6

0.32. Y

(a) 2.5

(b) 3

(c) 3.5

(d) 4

Q33. i

(a) 0.5

(b) 1

(c) 1.5

(d) 2

Q35. In view of your answers to [Q32-Q34] above, what can you say about monetary policy fixed ERs?

Q36-Q40 are based on [Situation 7] below:

Situation 7 -

-The Home country is pegging its currency to the foreign currency.

-The home country has been in the initial LR eq'm corresponding to [Situation 1].

-Today, the home central bank permanently devalues its currency, by raising E by 100% from what has prevailed in the initial LE eq'm (i.e., in situation 1).

-People know the devaluation is permanent.

-The new SR eq'm under fixed ER is called "Equilibrium 7."

Q36. [Choose the correct answers] The direct effect of devaluation is the shift of curve .

Q37. Suppose the magnitude of the shift in Q36 is 1. To support the above devaluation, what should the home central bank do in the SR?

(a) M^S ↑ by 1 

(b) M^S ↓ by 1

(c) M^S ↑ by 2

(d) no need to change M^S

[increase, decrease, invariant, or uncertain] Find the values of the following variables in Equilibrium 7.

Q38. Y

(a) 3.5

(b) 4

(c) 4.5

(d) 5

Q39. i

(a) 0.5

(b) 1

(c) 1.5

(d) 2

Q40. TB

(a) -0.5

(b) 0

(c) 0.5

(d) 1

Q41-Q47 are based on [Situation 8] below:

Situation 8 -

-The Home country is pegging its currency to the foreign currency.

-The home country has been in the initial LR eq'm corresponding to [Situation 1].

-Today, a huge cut in taxes is implemented in the foreign country.

Q41. Other things unchanged, what will happen to the foreign interest rate i* and the home IS curve, respectively?

(a) ↑, out

(b) ↑, in

(c) ↓, in

(d) ↓, out

Q42. Other things unchanged, how will the value of the home currency be affected by the foreign taxcut?

(a) the value will appreciate.

(b) the value will depreciate.

(c) the value will not change.

(d) the value will depreciate, but the change will be offset by foreign policies.

Suppose that the change in i* and the shift in the IS curve (as in Q41) are 2(%) and 1, respectively, in absolute terms. Consider the two scenarios below:

[Scenario Al The home central bank makes a solemn announcement "We will never surrender our peg", and investors acknowledge it.

[Scenario BI The governor of the home CB states "We are keeping an eye on the movement in the interest rate and its consequences on the economy", and investors acknowledge it.

Q43. In scenario A: what should the home CB do to maintain the peg?

(a) M^S is invariant

(b) M^S ↓ by 1

(c) M^S ↑ by 2

(d) M^S ↓ by 3

Q44. In scenario A: what is the cost of pegging, in terms of the output gap?

(a) 0

(b) 1

(c) 1.5

(d) 2

Q45. In scenario B: compared with [scenario A], how will the behavior of investors change in the FX market?

Q46. In scenario B: Suppose that the change in Q45 shifts vertically the FR line by 1, but does not affect the home IS curve. Calculate the cost of pegging.

(a) 0

(b) 1

(c) 1.5

(d) 2

Q47. Given the answers to Q44 and Q46, what can you say about survival/collapse of peg depending on the size of the benefits b > 0 from pegging?