Solution 1 Exchange Rates and Money 25 Marks 1 Assume that goods prices P are sticky
Solution Exchange Rates and Money Marks Assume that goods prices
Solution Exchange Rates and Money Marks Assume
Rates and Money Marks Assume that goods prices P are sticky
Solution Exchange Rates and Money Marks
Assume that goods prices P are sticky
Solution Exchange Rates and Money
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(Solution) 1 Exchange Rates and Money [25 Marks] 1. Assume that goods prices, P, are sticky.

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1 Exchange Rates and Money [25 Marks] 1. Assume that goods prices, P, are sticky. The central bank of Argentina announces that it is temporarily printing some additional pesos which it will use to buy Argentine government bonds, and that it plans to sell back all the bonds in one month's time. Draw a graph of how you expect the peso/$ exchange rate to respond during the next month, starting just before the announcement, with time on the x-axis and the exchange rate (E peso/$) on the y-axis. [7 Marks] 2. Explain the concept of Real Interest Parity. [3 Marks] 3. From which two theories is the theory of Real Interest Parity derived? Show how these theories together imply Real Interest Parity. [10 marks] 4. Are the theories you used in part (3) more likely to hold in the long-run or the short-run? How well would you expect the theory of Real Interest Parity to be supported by the data in practice? [5 marks] 2 Gains from Financial Globalization [25 Marks] In the 1990s the US bio-technology industry was on the cusp of major research breakthroughs, which with appropriate investment might yield many useful drugs. In 1995 annual US GDP was $10 trillion and the interest rate was 5%. If US entrepreneurs invested $1800 billion in 1995, their projects would yield an annual output of $300 billion every year from 1996 onwards (inclusive). Any international borrowing takes the form of a perpetual loan, in which the original principal borrowed is rolled over every year, while the US pays the interest in full every year. 1. What is the Net Present Value (NPV) of the investment in the bio-tech industry in 1995? Should US entrepreneurs go ahead with this investment or not? [5 marks] 2. The US economy is open to international capital flows, and US consumers have a preference for smoothing their consumption over time. If the investment in the bio-tech industry went ahead in 1995, how much would the US have to borrow from the rest of the world in 1995 to achieve the highest constant level of consumption that it could afford in 1995, 1996 and on into the future? [10 marks] 3. Assuming the US makes the investment and perfectly smoothes its consumption over time, calculate the US's trade balance in 1995 and 1996. Explain how the US Balance of Payments balances [5 marks] 4. Assume that the bonds issued to finance the debt of the US bio-tech firms are denominated in US$. How might a depreciation of the $ against other currencies after 2000 affect US net external wealth? [5 marks] 3 IS-LM Model [30 Marks] Assume goods prices, P, are completely fixed throughout this section. American consumers choose their consumption, C, using the following rule C = c0 + c1(Y - T) where c0 and c1 are positive constants, and Y -T is personal disposable income after taxation. 1. In the 1990s US households increased the share of income they chose to consume, and c1 increased. What effect would this increase in c1 have on aggregate demand for US goods? [2 marks] 2. Graph the IS curves that depict equilibrium in US goods markets before and after the increase in c1, labelling clearly which is which. Graph the LM curve that depicts equilibrium in US financial markets. [3 marks] 3. What is the effect of this increase in c1 on equilibrium US GDP and interest rates? [2 marks] 4. What is the effect of the increase in c1 on the $=€ exchange rate? [3 marks] 5. Explain the changes in the individual components of US GDP (C, I, G,TB) underlying the change in GDP you analysed in part (3). [5 marks] 6. The US government desires a medium-run improvement in the US's trade balance (to increase exports relative to imports). What fiscal or monetary policy adjustments could it make to bring this about? Explain how they would have this effect. [6 marks] 7. Can policymakers use either of these policies to improve the trade balance without causing a recession? (Explain your answer using the IS-LM model) [4 marks] 8. Why might the trade balance initially deteriorate before it eventually improves as a result of the policy you suggest? [5 marks]

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