Reference no: EM131089332

Public Affairs 854 Spring 2013 - Midterm 1

Part I - Multiple Choices

1. Under a fixed exchange rate regime, the official exchange rate

a. must collapse if the central bank no longer has foreign currency reserves.

b. must equate private supply and demand for a currency.

c. will lead to a balance of payments deficit.

d. is maintained by the central bank's willingness to buy and sell currency at the official rate.

e. none of the above.

2. A country is running a current account deficit. Which of the following might be true?

a. The central bank is reducing its holdings of foreign assets, but its residents are not reducing their holdings of foreign assets. The private financial account is in balance.

b. Official reserves transactions are zero and its residents are reducing their holdings of foreign assets.

c. The central bank is increasing its holdings of foreign assets, but its residents are not reducing their holdings of foreign assets. The private financial account is in balance.

d. (a) and (b).

e. none of the above.

3. Suppose today, the exchange rate (from the American perspective) was 1.60 $/£, and a year previously, it was 1.80 $/£. Then,

a. the pound has appreciated against the dollar over the past year.

b. compared against a year ago, it now takes more dollars to purchase a single pound.

c. the dollar has depreciated against the pound over the past year.

d. (a) and (b)

e. none of the above.

4. If the J-curve is a relevant phenomenon, then a devaluation will lead to

a. an initial improvement in the trade balance and a worsening in the long-run.

b. an initial worsening of the trade balance and an improvement in the long-run.

c. an initial worsening of the trade balance and a greater worsening in the long-run.

d. an initial improvement in the trade balance and a greater improvement in the long-run.

e. large short-run demand responses.

5. If the elasticity of export and import demands are 0.7 and 0.3 respectively, and the country initially has balanced trade, a devaluation will lead to

a. a trade deficit.

b. a trade surplus.

c. a decline in export revenue greater that the decline in import revenue.

d. no change in the trade balance.

e. none of the above.

6. A devaluation

a. raises the price paid by foreigners for domestic exports and lowers the price of imports.

b. does not change the price paid by foreigners for domestic exports and lowers the price of imports.

c. lowers the price paid by foreigners for domestic exports and lowers the price of imports.

d. lowers the price paid by foreigners for domestic exports and raises the price of imports.

e. raises the price paid by foreigners for domestic exports and raises the price of imports.

7. A country running a current-account surplus is

a. reducing claims on foreigners.

b. building up a positive net foreign asset position.

c. reducing its net foreign asset position.

d. accumulating claims on foreigners.

e. (b) and (d).

Part II: Short Answer

Consider the following economy:

Eq.No. Equation                               Description

(1) Y = AD                                      Output equals aggregate demand, an equilibrium condition

(2) AD ≡ C + I + G + EX - IM           Definition of aggregate demand

(3) C = C^-O^- + c(Y - T + TR)            Consumption function, c is the MPC

(4) T = tY                                        Tax function; t is tax rate.

(5) TR = (TR)^-                                 Transfers function (e.g., social security payments)

(6) I = (IN)^-                                    Investment function

(7) G = G^-O^-                                   Government spending on goods and services

(9) EX = E^-(XP)^- + nq                      Export spending

(10) IM = (IMP)^- + mY - vq              Import spending

Assume the real exchange rate is constant.

1. Solve for Y. Show your work.

2. Calculate the change in income for a change in the real exchange rate. Show your work!

3. Calculate the change in the trade balance for a given change in the real exchange rate. Hint: TB ≡ EX - IM. Show your work!

4. Calculate the change in the budget balance for a change in the real exchange rate. Hint: BuS ≡ T - G -TR. Show your work!

5. Explain the economics of why you obtain the results in 4.

Now consider an IS-LM-BP=0 model under fixed exchange rates.

6. Draw the economy in an initial state of equilibrium, assuming capital mobility is low (that is m/κ > k/h).

7. Show what happens to output and interest rates in the short term when the real exchange rate is devalued. Assume sterilization.

8. Show what happens to output and interest rates in the short and longer term if the exchange rate is devalued, but the central bank does not sterilize capital flows.