Intermediate macroeconomics with solutions

UNIVERSITY OF MELBOURNE
DEPARTMENT OF ECONOMICS
SEMESTER 2, 2017
ECON20001 INTERMEDIATE MACROECONOMICS
WITH SOLUTIONS [DRAFT]
Reading Time: 15 minutes
Writing Time: 2 hours
This examination paper contributes 60 percent to the assessment in ECON20001.
The PAPER and RESPONSE SHEET should both be inserted in the back of the examination
booklet at the end of the examination. For the multiple-choice questions, you may use the
examination script books to draw diagrams or make notes to help you. These diagrams or notes
will not be taken into account for your assessment.
The following items are authorised in the exam room:
– Print dictionary that translates English into a foreign language.
– The approved calculator is the Casio FX82. No equivalent models of calculators will be
permitted.
This exam has 18 pages.
There are a total of 60 marks for this examination.
This paper is not to be removed from the exam room.
This paper will not be held in the Baillieu Library.
SECTION A: ANSWER ALL QUESTIONS
This part contributes 20 marks to this examination.
Suggested time allocation: 40 minutes.
Answer all questions. For each question, using a 2B pencil, fill in the appropriate small circle on
the RESPONSE SHEET. Please follow the SAMPLE RESPONSE SHEET for details required
on the formal RESPONSE SHEET. All questions are equally weighted. Incorrect answers, no
answer or more than one answer, will all receive a zero mark.
SECTION B: ANSWER TWO OUT OF THREE QUESTIONS
This part contributes 20 marks to this examination.
Suggested time allocation: 40 minutes.
Answer the questions in the examination booklet(s) provided.
SECTION C: ANSWER TWO OUT OF THREE QUESTIONS
This part contributes 20 marks to this examination.
Suggested time allocation: 40 minutes.
Answer the questions in the examination booklet(s) provided.
Page 1 of 18
SECTION A
This section is compulsory and contains 12 multiple-choice questions. Suggested
time allotment: 40 minutes for the section, slightly over 3 minutes per response.
All questions are equally weighted.
A1. Consider a simple closed economy model where Y = C + I + G, consumption is given by
the function C = 100 + (2/3)(Y βˆ’ T), investment is I = 50, government purchases are
G = 20, and net taxes are T = 30. Which of the following is false?
(a) the multiplier is 3.0
(b) the budget deficit is 10 +
(c) autonomous spending is 150
(d) equilibrium disposable income is 420
A2. In the IS-LM model, when the nominal interest rate is zero, which of the following must
be true?
(a) an increase in money supply leads to a rise in output
(b) an increase in government spending does not affect output
(c) an increase in money supply leads to a lower nominal interest rate
(d) an increase in government spending does not affect the nominal interest rate +
A3. In the IS-LM diagram below, which of the following statement regarding to point A is
true?
(a) excess supply in goods market and excess supply in money (or financial) market
(b) excess supply in goods market and excess demand in money (or financial) market +
(c) excess demand in goods market and excess demand in money (or financial) market
(d) excess demand in goods market and excess supply in money(or financial) market
Final exam
𝐴𝐴
𝐿𝐿𝐿𝐿
𝐼𝐼𝐼𝐼
π‘–π‘–βˆ—
π‘Œπ‘Œβˆ—
𝑖𝑖
π‘Œπ‘Œ
Page 2 of 18
A4. Consider the static AS-AD model. Suppose the actual price level is less than the price
level individuals expect. Which of the following is true?
(a) output is currently less than the natural level of output +
(b) the AS curve will tend to shift up over time
(c) the AD curve will tend to shift up over time
(d) the nominal wage will tend to increase as individuals revise their expectations
A5. Consider the dynamic AS-AD model. Which of the following is false if there is an increase
in the natural level of output?
(a) the DAD curve shifts to the right
(b) the DAS curve shifts to the right
(c) inflation increases +
(d) output increases
A6. Which of the following is false? In the dynamic AS-AD model,
(a) the more reactive the central bank is to output, the less volatile output is
(b) there is a long-run tradeoff between output and inflation +
(c) the Taylor principle is satisfied if ΞΈΟ€ > 0
(d) the Taylor principle implies that the real interest rate should rise when inflation
increases
A7. Consider the basic Solow model with production function Y = KΞ±N 1βˆ’Ξ± and no employment growth. Which of the following must be true if the saving rate increases?
(a) consumption per worker decreases in the long run
(b) total capital stock decreases in the long run +
(c) the growth rate of capital per worker decreases in the long run
(d) the growth rate of total output decreases in the long run
A8. Consider the basic Solow model with production function Y = K1/3N 2/3 and no employment growth. Suppose that the saving rate is 20% and the depreciation rate is 5%. Which
of the following is false?
(a) investment per worker is 8 +
(b) output per worker is 2
(c) capital’s share of national income is 1/3
(d) consumption per worker is 1.6
Page 3 of 18
A9. Suppose that production function is Y = AK1/2N 1/2 and competitive firms hire capital
and labor to produce output. Let r be the return paid to capital and w be the real wage
paid to labor. Which of the following is false?
(a) increases in productivity raise demand for labor
(b) increases in productivity raise demand for capital
(c) real wage w grows at the rate of productivity growth
(d) none of the above +
A10. Assume that the domestic economy is an open economy. Which of the following will make
the government spending multiplier smaller?
(a) a move towards a more closed economy
(b) a decrease in foreign output
(c) an increase in the marginal propensity to consume
(d) an increase in the marginal propensity to import +
A11. Assume that policy makers are pursuing a fixed exchange rate regime and that the economy
is initially operating at the natural level. Which of the following occur as a result of a
devaluation?
(a) the real exchange rate will be permanently higher in the long run
(b) the real exchange rate will be the same in the long run+
(c) the real exchange rate will be permanently lower in the long run
(d) the effects of this devaluation on the real exchange rate will be ambiguous in the long
run
A12. Consider the model of monetary policy rules versus discretion. The central bank’s loss
function is L = (u, Ο€) = u2 + Ξ³Ο€2. In equilibrium, which of the following is false?
(a) with discretion, a central banker that has a higher Ξ³ leads to a lower inflation
(b) with discretion, inflation is higher than with a rule
(c) with discretion, unemployment is higher than with a rule +
(d) none of the above
Page 4 of 18
SECTION B
This section is compulsory and is worth 20 marks. Answer two of the following
three questions. Each question is worth 10 marks. Suggested time: 40 minutes.
B1. Labor market flows. Suppose the change in unemployment ut is given by
ut+1 βˆ’ ut = s(1 βˆ’ ut) βˆ’ fut
(a) Solve for the steady-state unemployment rate. If the economy goes into a boom and
the job finding rate f increases, would you expect to find the proportion of long-term
unemployment workers higher or lower? Explain. (2 points)
(b) Consider two economies A and B. Economy B has a more fluid labor market where
both the job finding rate and the job separation rate are twice as big as the job
finding rate and the job separation rate in economy A, respectively. How do you
compare the steady-state unemployment rates between economy A and economy B?
Which economy has a faster speed with which the economy responds to unemployment
shocks? Explain. (2 points)
(c) Suppose now that f(ΞΈt) = AΞΈt 1/2. The labor market tightness ΞΈt is defined as ΞΈt = vt/ut
where vt is the job vacancy rate. Derive the Beveridge curve and explain how vt and ut
are related. How would an increase in the matching efficiency A affects the Beveridge
curve? Explain. (3 points)
(d) Suppose that firms post vacancies until the vacancy filling rate q(ΞΈt) satisfies q(ΞΈt)J =
c, where q(ΞΈt) is the vacancy filling rate, J is the value of a filled position and c is the
cost of creating a vacancy. Solve for the expressions of the equilibrium labor market
tightness ratio ΞΈβˆ— and the steady-state unemployment rate. (3 points)
[Total: 10 marks]
(a) Steady state unemployment is u = s/(s + f). The duration of unemployment is given
by 1/f. Given that f increases, the duration of unemployment should decrease and
the proportion of long-term unemployment workers should decrease.
(b) Economy A and economy B have the same steady-state unemployment rate because
when both s and f are doubled, it does not affect the steady-state unemployment
rate. The speed of adjustment to unemployment shocks is given by 1 βˆ’ s βˆ’ f. Therefore, economy B which has a more fluid labor market has a faster speed with which
the economy responds to unemployment shocks. In economy B, there are more job
seperations and job findings, it takes a shorter time for the economy to return to its
steady-state unemployment if the unemployment rate deviates from the steady state.
(c) The Beveridge curve is given by
vt =
s2(1 βˆ’ ut)2
A2ut
Page 5 of 18
Notice that the numerator on the right-hand-side of the Beveridge curve is decreasing
in ut and the denominator on the right-hand-side of the Beveridge curve is increasing
in ut. It implies that vt is negatively related to ut. When the matching efficiency A
increases, it means that for any given ut, vt should decrease. The Beveridge curve
should shift in as a result of the improvement in the matching efficiency.
(d) The job creation decision gives q(ΞΈt)J = c. The vacancy filling rate q(ΞΈt) can be found
by
q(ΞΈ) = f(ΞΈt)/ΞΈt = AΞΈt βˆ’1/2 = c
J
It follows that the steady-state labor market tightness is
ΞΈ = (AJ
c
)2
Substituting vt = ΞΈut into the Beveridge curve,
(AJ
c
)2u = s2(1 βˆ’ u)2
A2u
The steady-state unemployment rate is therefore
u =
sc
sc + A2J
Page 6 of 18
B2. Dynamic AS-AD model. Consider a dynamic AS-AD model where vt = t = 0. The DAS
curve is
Ο€t = Ο€tβˆ’1 + 0.4(Yt βˆ’ 100)
and the DAD curve is
Yt = 100 βˆ’ 0.5(Ο€t βˆ’ 4)
Suppose that the output equation is given by
Yt = 100 βˆ’ 0.5(rt βˆ’ 2)
(a) Compute the long run equilibrium values for output, inflation, nominal interest rate
and real interest rate. (2 points)
Now suppose that the economy is in the long run equilibrium from part (a) and then at
time t = 1, the central bank decides to lower the inflation target to a new target level
Ο€βˆ—βˆ— = 2.5.
(b) Compute the values of output, inflation, nominal interest rate and real interest rate
at time t = 1. (2 points)
(c) With the help of a diagram, explain qualitatively the subsequent time paths of output
and inflation after the change in inflation target. Can inflation and output return to
their long run equilibrium values? Carefully label your diagram. (3 points)
(d) ”If a central bank wants to achieve lower interest rates, it has to raise the nominal
interest rate”. Using your findings from the previous parts of this question, explain
in what way this statement makes sense. (3 points)
[Total: 10 marks]
(a) In the long run where Ο€t = Ο€tβˆ’1, we have Yt = Y Β― = 100. It follows that Ο€βˆ— = 4, r = 2
and i = 6.
(b) At time t = 1, the DAS curve becomes
Ο€1 = Ο€βˆ— + 0.4(Y1 βˆ’ 100)
and the DAD curve becomes
Y1 = 100 βˆ’ 0.5(Ο€1 βˆ’ Ο€βˆ—βˆ—)
Notice that Ο€βˆ— = 4 and Ο€βˆ—βˆ— = 2.5. Solving these two equations for two unknowns Ο€1
and Y1, we find Ο€1 = 3.75 and Y1 = 99.375. Using the output equation,
Y1 = 100 βˆ’ 0.5(r1 βˆ’ 2)
we have r1 = 3.25. From the Fisher equation, i1 = r1 + Ο€1 = 7.
Page 7 of 18
(c) With the decrease in inflation target, the DAD curve shifts to the left, which leads to
lower inflation and lower output on impact. As inflation decreases, expected inflation
adjusts and the DAS curves begins to shift to the right from time t = 2 until the
economy is back to Y = Y Β― and the long run inflation rate is at the lower level.
Output returns to the natural output level, but inflation will remain at the lower
B2 target level.
C3
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2
2.5
4
C
B
𝐷𝐴𝑆
0,1
A
output
inflation
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0
𝐷𝐴𝐷
1
ΰ΄€ π‘Œ
interest
rate
4.5
6
B
𝐿𝑀
0
A
output
𝐼𝑆
0
𝐿𝑀
1
Figure 1: An increase in the inflation target
(d) To achieve lower interest rates in the long run, the central bank needs to lower the
inflation target. When the inflation target decreases, it raises the inflation gap which
requires the real interest rate to rise if Taylor Principle is satisfied. Here the rise in
the real interest rate is more than the decrease in the inflation rate at time t = 1.
Therefore, the nominal interest rate also rises at time t = 1. It implies that the
central bank actually raises the nominal interest rate in order to achieve lower nominal
interest rates in the long run.
Page 8 of 18
B3. Growth accounting. Suppose output is given by the production function Y = AK0.3N 0.7.
We have the data:
K/N Y/N H
Australia 1950 65 33 2.67
1980 170 54 3.21
2014 330 84 3.8
where K/N and Y/N are in real US dollars, and H is an index of human capital based on
years of schooling and return to education.
(a) Calculate the level of TFP for Australia in each year (1950, 1980 and 2014). Which
episode (from 1950 to 1980 and from 1980 to 2014) has a higher growth rate of TFP?
(3 points)
(b) Consider the source of growth in output per worker for each episode (from 1950 to
1980 and from 1980 to 2014). Use the growth accounting methodology to allocate
growth in output per worker to TFP growth and capital accumulation. Which factor
is more important in accounting for growth in output per worker in each episode?
(3 points)
(c) Now suppose that the true production function is Y = AK0.3(NH)0.7. With this new
production function, find how your answers in part (a) change. (3 points)
(d) Following part (c), what is the potential problem if we use the wrong production
function as in part (a) to estimate the level of TFP? (1 point)
[Total: 10 marks]
(a) From the production function, we can derive the level of TFP A = (Y/N)/(K/N)0.3.
Using this formula, we find for Australia, A = 9.433 in 1950, A = 11.568 in 1980 and
A = 14.748 in 2014. Using the levels of TFP, we can compute the growth rate of
TFP from 1950 to 1980 as 0.68% and the growth rate of TFP from 1980 to 2014 as
0.714%. The episode from 1980 to 2014 has a higher growth rate of TFP.
(b) We define the growth rate of output per worker from 1950 to 1980 by
gY/N =
ln(Y/N)1980 βˆ’ ln(Y/N)1950
1980 βˆ’ 1950
This gives gY/N = 1.642% from 1950 to 1980. We can also compute the growth rate
of output per worker from 1980 to 2014, gY/N = 1.300%. Similarly, we can compute
gK/N = 3.205% from 1950 to 1980 and gK/N = 1.951% from 1980 to 2014. The growth
rate decomposition implies
gY/N = gA + Ξ±gK/N
Page 9 of 18
where Ξ± = 0.3 here. We can derive gA = gY/N βˆ’Ξ±gK/N. We can verify that the growth
rates of TFP for each episode are the same as we calculated in part (a). From 1950
to 1980, growth in capital accumulation accounts for
0.3gK/N
gY/N
=
0.3 Γ— 3.205%
1.642% = 58.566%
of growth in output per worker and growth in TFP accounts for 41.434% of growth
in output per worker. From 1980 to 2014, growth in capital accumulation accounts
for
0.3gK/N
gY/N
=
0.3 Γ— 1.951%
1.300% = 45.037%
of growth in output per worker and growth in TFP accounts for 54.963% of growth
in output per worker. Capital accumulation is more important from 1950 to 1980,
while TFP growth is more important from 1980 to 2014.
(c) Using the new production function, we can derive the level of TFP as
A = (Y
N
) Γ· ((K
N
)0.3H0.7)
Now TFP in Australia is A = 4.743 in 1950, A = 5.113 in 1980 and A = 5.793 in
2014. The growth rate of TFP is thus 0.250% from 1950 to 1980 and 0.367% from
1980 to 2014. The growth rate of TFP is much higher from 1980 to 2014.
(d) Using the production function in part (a) would give a wrong estimate of TFP, which
includes both TFP and human capital.
Page 10 of 18
SECTION C
This section is compulsory and is worth 20 marks. Answer two of the following
three questions. Each question is worth 10 marks. Suggested time: 40 minutes.
C1. IS-LM model. Consider an IS-LM model. The consumption and investment functions are
C = 50 + 0.5(Y βˆ’ T)
and
I = 100 + 0.3Y βˆ’ 2000i
Suppose G = 100 and the government has a balanced budget. Let the money demand
function be
M/P = Y βˆ’ 4000i
and let M/P = 300.
(a) Solve for the equilibrium values of real output Y and interest rate i. (2 points)
(b) Now suppose that the central bank wants to achieve a particular interest rate, i = 0.04.
How should the central bank adjust the real money supply? Solve for the equilibrium
values of Y and M/P. (2 points)
(c) Set M/P back to 300. Now suppose that government spending increases to G = 150
without changing taxes T. If the central bank keeps the real money supply M/P
unchanged, what are the effects of this fiscal expansion on Y and i? (2 points)
(d) Set M/P back to 300. Now suppose that government spending is a function of
aggregate output Y . In particular, G = 0.2Y . Again assuming that the government
has a balanced budget. Solve for the equilibrium values of real output Y and interest
rate i. (2 points)
(e) Following part (d), suppose that the central bank now wants to achieve the interest
rate i = 0.04. How should the central bank adjust the real money supply? Solve for
the equilibrium values of Y and M/P. Explain why your answers are different from
your findings in part (b). (2 points)
[Total: 10 marks]
(a) Goods market equilibrium condition is
Y = C + I + G = 50 + 0.5(Y βˆ’ T) + 100 + 0.3Y βˆ’ 2000i + G
Plugging in G = 100 and T = 100, we have
Y = 200 + 0.8Y βˆ’ 2000i
Page 11 of 18
Money market equilibrium condition is
300 = Y βˆ’ 4000i
We can use the two equations to solve for two unknowns, wherei = 0.05 and Y = 500.
(b) Now the central bank sets the interest rate. We can use the goods market equilibrium
condition to find Y = 600. Then the money market equilibrium condition gives
M/P = 440.
(c) Using G = 150 in the goods market equilibrium condition, we have Y = 250+0.8Y βˆ’
2000i. Together with the money market equilibrium condition, we find equilibrium
i = 0.068 and Y = 572. The fiscal expansion leads to a higher interest rate and a
higher level of output.
(d) When the government spending is a function of output, we rewrite the goods market
clearing condition by substituting G and T by 0.2Y . We have 0.1Y = 150 βˆ’ 2000i.
Together with the money market equilibrium condition where 300 = Y βˆ’ 4000i, we
solve for i = 0.05 and Y = 500.
(e) When the central bank sets the interest rate at i = 0.04, we can use the goods market
equilibrium condition derived in part (d) to find Y = 700. Then using the money
market equilibrium condition, we find M/P = 540. In this case, both government
spending and taxes are functions of output. The IS curve is flatter. To achieve the
same target of a lower interest rate, monetary policy needs to be more expansionary.
Therefore, we see that in part (e) the real money supply is 540, which is higher than
440 found in part (b).
Page 12 of 18
C2. Endogenous growth model. Consider the endogenous growth model with production function Y = AK, productivity level A = 1/4, saving rate s = 0.3, depreciation rate Ξ΄ = 0.05
and no growth in productivity.
(a) Calculate the growth rates of output and capital. How do the growth rates depend
on s and Ξ΄? (2 points)
(b) What is the steady-state capital/output ratio? How does it depend on s and Ξ΄?
(2 points)
The above AK model is the simplest model of endogenous growth. Now we consider an
alternative model that also generates endogenous growth. Suppose that the economy has
two sectors, which we call manufacturing firms and research universities. Firms produce
goods, which are used for consumption and investment in physical capital. Universities
produce a factor of prodution called ”knowledge,” which is then freely used in both sectors.
The production function for firms in period t is Yt = KtΞ±[(1 βˆ’ Ξ³)NEt](1βˆ’Ξ±), where Kt is
the stock of physical capital, Et is the stock of knowledge and N is the constant amount
of labor input. There are two parameters in the production function: 0 < Ξ± < 1 as in the
standard Solow model and Ξ³ is the fraction of employment in universities. Therefore, 1βˆ’Ξ³
is the fraction of employment in manufacturing. The knowledge accumulation equation is
Et+1 βˆ’ Et = g(Ξ³)Et, where g(Ξ³) is an increasing function of Ξ³ that shows how the growth
of knowledge depends on the fraction of employment in universities. Lastly, the capital
accumulation equation is Kt+1 βˆ’ Kt = sYt βˆ’ Ξ΄Kt.
(c) Consider the balanced growth path where the growth rate of physical capital equals
the growth rate of knowledge. What is the growth rate of physical capital and knowledge? (2 points)
(d) Derive an expression that shows how output Yt depends on physical capital Kt. What
is the capital/output ratio in this economy? How does it depend on parameters such
as s, Ξ΄ and Ξ³? (2 points)
(e) Following part (d), what is the growth rate of output in this economy? How does the
growth rate of output depend on parameters such as s, Ξ΄ and Ξ³? In what sense is this
an endogenous growth model? Explain. (2 points)
[Total: 10 marks]
(a) In the AK model, the growth rate of output and capital is g = sAβˆ’Ξ΄ = 0.3/4βˆ’0.05 =
0.025. A higher s or a lower Ξ΄ contributes to a higher growth rate.
(b) The steady-state capital/output ratio is K/Y = 1/A = 4. This ratio does not depend
on s and Ξ΄.
(c) On the balanced growth path, both knowledge and physical capital grow at the same
rate. From the knowledge accumulation equation, we can find the growth rate of
knowledge is g(Ξ³). It follows that the growth rate of physcial capital is also g(Ξ³).
Page 13 of 18
(d) From the physical capital accumulation equation, we find
g(Ξ³)Kt = sYt βˆ’ Ξ΄Kt
It follows that
Yt = g(Ξ³) + Ξ΄
s
Kt
The capital output ratio is therefore s/[g(Ξ³) + Ξ΄]. This ratio depends positively on s
and negatively on Ξ³ and Ξ΄.
(e) The growth rate of output is the same as the growth rate of physical capital which
is g(Ξ³). This growth rate does not depend on the saving rate and depreciation rate.
It depends only on the parameter Ξ³. This is an endogenous growth model because
the production function collapse into an ”AK” production function. The growth in
output is not driven by productivity growth, but is driven by knowledge accumulation
and the function g(Ξ³).
Page 14 of 18
C3. Mundell-Fleming model. Consider an open economy IS-LM model. China’s currency is
the β€œChinese Yuan Renminbi (CNY)” and the USA’s currency is the β€œUS dollar (USD)”.
China has a fixed exchange rate regime with respect to USD. The central bank of China
maintains a peg of 1 CNY=0.125 USD. The interest rate in the USA is 4.5%.
(a) What do the above facts imply about the interest rate in China? Explain. (1 point)
(b) Suppose that the USA experiences an increase in output Y βˆ—. With the help of a
diagram, explain the short-run effects of the increase in Y βˆ— on the economy of China.
What happens to output and net exports? Carefully label your diagram. (2 points)
(c) Suppose the USA Federal Reserve Bank conducts an expansionary monetary policy
and lowers its interest rate to 3%. How will the central bank of China react if it wants
to maintain the exchange rate peg? What will be the effect of this on the interest
rate in China? (1 point)
(d) Following part (c), with the help of a diagram, explain the short-run effects of the
foreign expansionary monetary policy on the economy of China. What happens to
output and net exports? (2 points)
(e) Suppose instead that China decides to abandon the fixed exchange rate regime and
to adopt a flexible exchange rate regime. With the help of a diagram, explain how
your answers in part (b) would change? What would happen to the nominal exchange
rate? (2 points)
(f) Suppose that China adopts a flexible exchange rate regime. With the help of a
diagram, explain how your answers in part (d) would change? What would happen
to the nominal exchange rate? (2 points)
[Total: 10 marks]
(a) From the interest parity condition, the interest rate in China equals the interest rate
in USA. That is, i = 4.5%.
(b) If foreign demand rises, the IS curve shifts to the right. To maintain the fixed exchange
rate, the LM curve also shifts to the right. Output increases. Imports increase because
domestic output increases. Exports increase because foreign output increases. Net
exports may increase or decrease because both imports and exports increase.
(c) If the interest rate in USA falls, the interest rate in China also falls to 3%. The
central bank in China needs to use an expansionary monetary policy to maintain the
fixed exchange rate.
(d) The LM curve shifts to the right. It implies that output in China rises. Since output
rises, imports also rises and net exports decrease.
Page 15 of 18
𝐿𝑀
0
𝐼𝑆
1
interest
rate
B
𝐿𝑀
1
A
output
𝐼𝑆
0
𝐿𝑀
1
𝐼𝑆
0
interest
rate
B
𝐿𝑀
0
A
output
𝐼𝑆
1
Figure 2: Part b – a rise in foreign output
(e) If China abandons the fixed exchange rate regime, the central bank in China does not
need to conduct the expansionary monetary policy to maintain the fixed exchange
rate. In this case, only the IS curve shifts to the right. Output rises and interest rate
increases. The higher interest rate leads to a rise in nominal exchange rate. That is,
the Chinese currency appreciates. The rise in output in China and the USA tends to
increase both imports and exports for China. The appreciation of Chinese currency
tends to lower net exports. Overall, the effect on net exports is ambiguous.
(f) If China abandons the fixed exchange rate regime, the IS curve shifts to the left as a
result of a lower foreign interest rate because the lower foreign interest rate depreciates
foreign currency and appreciates domestic currency. Output falls and interest rate
decreases. The effect on the nominal exchange rate is ambiguous, depending on the
relative magnitude of the fall in interest rates in China and USA. Overall, the effect
on net exports is also ambiguous.
END OF EXAMINATION
Page 16 of 18
B2
C3
(d)
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2
2.5
4
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B
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0,1
A
output
inflation
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0
𝐷𝐴𝐷
1
ΰ΄€ π‘Œ
interest
rate
3
4.5
A
𝐿𝑀
1
B
output
𝐼𝑆
0
𝐿𝑀
0
Figure 3: Part d – a fall in foreign interest rate
(f)
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0
𝐼𝑆
1
interest
rate
A
𝐿𝑀
0
B
output
Figure 4: Part e – a rise in domestic demand under fixed exchange rate regime
Page 17 of 18
(b)
(e)
𝐿𝑀
0
𝐼𝑆
1
interest
rate
B
𝐿𝑀
1
A
output
𝐼𝑆
0
𝐿𝑀
1
𝐼𝑆
0
interest
rate
B
𝐿𝑀
0
A
output
𝐼𝑆
1
Figure 5: Part f – a fall in foreign interest rate under flexible exchange rate regime
Page 18 of 18

 

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