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:

β Print dictionary that translates English into a foreign language.

β 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 **β **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

π΄π΄

πΏπΏπΏπΏ

πΌπΌπΌπΌ

ππβ

ππβ

ππ

ππ

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 *ΞΈ**Ο **> *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 *= *K**Ξ±**N *1*β**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 *= *K*1*/*3*N *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) capitalβs 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 *= *AK*1*/*2*N *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 bankβs loss

function is *L *= (*u, Ο*) = *u*2 + *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 *u**t *is given by

*u**t*+1 *β **u**t *= *s*(1 *β **u**t*) *β **fu**t*

(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*(*ΞΈ**t*) = *AΞΈ**t *1*/*2. The labor market tightness *ΞΈ**t *is defined as *ΞΈ**t *= *v**t**/u**t*

where *v**t *is the job vacancy rate. Derive the Beveridge curve and explain how *v**t *and *u**t*

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*(*ΞΈ**t*) satisfies *q*(*ΞΈ**t*)*J *=

*c*, where *q*(*ΞΈ**t*) 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 *ΞΈ**β *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 *β **s **β **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

*v**t *=

*s*2(1 *β **u**t*)2

*A*2*u**t*

Page 5 of 18

Notice that the numerator on the right-hand-side of the Beveridge curve is decreasing

in *u**t *and the denominator on the right-hand-side of the Beveridge curve is increasing

in *u**t*. It implies that *v**t *is negatively related to *u**t*. When the matching efficiency *A*

increases, it means that for any given *u**t*, *v**t *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*(*ΞΈ**t*)*J *= *c*. The vacancy filling rate *q*(*ΞΈ**t*) can be found

by

*q*(*ΞΈ*) = *f*(*ΞΈ**t*)*/ΞΈ**t *= *AΞΈ**t **β*1*/*2 = *c*

*J*

It follows that the steady-state labor market tightness is

*ΞΈ *= (*AJ*

*c*

)2

Substituting *v**t *= *ΞΈu**t *into the Beveridge curve,

(*AJ*

*c*

)2*u *= *s*2(1 *β **u*)2

*A*2*u*

The steady-state unemployment rate is therefore

*u *=

*sc*

*sc *+ *A*2*J*

Page 6 of 18

B2. *Dynamic AS-AD model. *Consider a dynamic AS-AD model where *v**t *= *t *= 0. The DAS

curve is

*Ο**t *= *Ο**t**β*1 + 0*.*4(*Y**t **β *100)

and the DAD curve is

*Y**t *= 100 *β *0*.*5(*Ο**t **β *4)

Suppose that the output equation is given by

*Y**t *= 100 *β *0*.*5(*r**t **β *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**ββ *= 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) βIf a central bank wants to achieve lower interest rates, it has to raise the nominal

interest rateβ. 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**t**β*1, we have *Y**t *= *Y *Β― = 100. It follows that *Ο**β *= 4*, r *= 2

and *i *= 6.

(b) At time *t *= 1, the DAS curve becomes

*Ο*1 = *Ο**β *+ 0*.*4(*Y*1 *β *100)

and the DAD curve becomes

*Y*1 = 100 *β *0*.*5(*Ο*1 *β **Ο**ββ*)

Notice that *Ο**β *= 4 and *Ο**ββ *= 2*.*5. Solving these two equations for two unknowns *Ο*1

and *Y*1, we find *Ο*1 = 3*.*75 and *Y*1 = 99*.*375. Using the output equation,

*Y*1 = 100 *β *0*.*5(*r*1 *β *2)

we have *r*1 = 3*.*25. From the Fisher equation, *i*1 = *r*1 + *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

π·π΄π

2

2.5

4

C

B

π·π΄π

0,1

A

output

inflation

π·π΄π·

0

π·π΄π·

1

ΰ΄€ π

interest

rate

4.5

6

B

πΏπ

0

A

output

πΌπ

0

πΏπ

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 *= *AK*0*.*3*N *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 *= *AK*0*.*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

*g**Y/N *=

ln(*Y/N*)1980 *β *ln(*Y/N*)1950

1980 *β *1950

This gives *g**Y/N *= 1*.*642% from 1950 to 1980. We can also compute the growth rate

of output per worker from 1980 to 2014, *g**Y/N *= 1*.*300%. Similarly, we can compute

*g**K/N *= 3*.*205% from 1950 to 1980 and *g**K/N *= 1*.*951% from 1980 to 2014. The growth

rate decomposition implies

*g**Y/N *= *g**A *+ *Ξ±g**K/N*

Page 9 of 18

where *Ξ± *= 0*.*3 here. We can derive *g**A *= *g**Y/N **β**Ξ±g**K/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*.*3*g**K/N*

*g**Y/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*.*3*g**K/N*

*g**Y/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*.*3*H*0*.*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 **β **T*)

and

*I *= 100 + 0*.*3*Y **β *2000*i*

Suppose *G *= 100 and the government has a balanced budget. Let the money demand

function be

*M/P *= *Y **β *4000*i*

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*.*2*Y *. 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 **β **T*) + 100 + 0*.*3*Y **β *2000*i *+ *G*

Plugging in *G *= 100 and *T *= 100, we have

*Y *= 200 + 0*.*8*Y **β *2000*i*

Page 11 of 18

Money market equilibrium condition is

300 = *Y **β *4000*i*

We can use the two equations to solve for two unknowns, where*i *= 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*.*8*Y **β*

2000*i*. 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*.*2*Y *. We have 0*.*1*Y *= 150 *β *2000*i*.

Together with the money market equilibrium condition where 300 = *Y **β *4000*i*, 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 βknowledge,β which is then freely used in both sectors.

The production function for firms in period *t *is *Y**t *= *K**tΞ±*[(1 *β **Ξ³*)*NE**t*](1*β**Ξ±*), where *K**t *is

the stock of physical capital, *E**t *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, 1*β**Ξ³*

is the fraction of employment in manufacturing. The knowledge accumulation equation is

*E**t*+1 *β **E**t *= *g*(*Ξ³*)*E**t*, 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 *K**t*+1 *β **K**t *= *sY**t **β **Ξ΄K**t*.

(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 *Y**t *depends on physical capital *K**t*. 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 *= *sA**β**Ξ΄ *= 0*.*3*/*4*β*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*)*K**t *= *sY**t **β **Ξ΄K**t*

It follows that

*Y**t *= *g*(*Ξ³*) + *Ξ΄*

*s*

*K**t*

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 βAKβ 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. Chinaβs currency is

the βChinese Yuan Renminbi (CNY)β and the USAβs currency is the βUS dollar (USD)β.

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 **β*. With the help of a

diagram, explain the short-run effects of the increase in *Y **β *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

πΏπ

0

πΌπ

1

interest

rate

B

πΏπ

1

A

output

πΌπ

0

πΏπ

1

πΌπ

0

interest

rate

B

πΏπ

0

A

output

πΌπ

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)

π·π΄π

2

2.5

4

C

B

π·π΄π

0,1

A

output

inflation

π·π΄π·

0

π·π΄π·

1

ΰ΄€ π

interest

rate

3

4.5

A

πΏπ

1

B

output

πΌπ

0

πΏπ

0

Figure 3: Part d – a fall in foreign interest rate

(f)

πΌπ

0

πΌπ

1

interest

rate

A

πΏπ

0

B

output

Figure 4: Part e – a rise in domestic demand under fixed exchange rate regime

Page 17 of 18

(b)

(e)

πΏπ

0

πΌπ

1

interest

rate

B

πΏπ

1

A

output

πΌπ

0

πΏπ

1

πΌπ

0

interest

rate

B

πΏπ

0

A

output

πΌπ

1

Figure 5: Part f – a fall in foreign interest rate under flexible exchange rate regime

Page 18 of 18

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