The 3rd Assignment of Principles of Macroeconomics

ECON2003, 1 st sem, 2023-24

Question 1 (28 marks total)

Consider the economies of three countries, A,B, and C. Their currencies are $A, $B, and $C respectively. Country A trades with its two neighboring countries B and C.  The nominal exchange rates among their currencies currently are:

1 $A =  4  $B

1 $A = 200 $C

1 $B = 100 $c

Steak Burgers are produced and consumed in all three countries. One Steak Burger costs $A2 in Country A, $B 16 in Country B, and $C600 in Country C. Answer the following questions based on information provided above:

a)    From Country A’s perspective, calculate the real exchange rate of Steak Burger between Countries A and B. Explain in words what the number you calculated means.  (4 marks)

b)    Explain whether the purchasing power parity (PPP) is satisfied by the current nominal exchange rate between $A  and $B  so far as the Steak Burger is concerned. If your answer is no, give two possible reasons as to why the PPP is not satisfied. (4 marks)

c)    In your prediction, how will the nominal exchange rate between $A  and $B  change in the future? Explain, assuming that the Steak Burger is the only final good produced and consumed in Countries A and B. (3 marks)

d)    How would your prediction be different if Steak Burger is only one out of thousands of final goods produced and consumed in Countries A and B? Explain.                 (3 marks)

e)    Suppose next year that the real output in Countries A and B will grow 8% and 12% respectively, and the money supply in Countries A and B will increase by 10% and 30% respectively. Give your best estimate of the nominal exchange rate between $A  and $B next year. Explain and show calculations.                     (5 marks)

f)    As you can judge from information given, is it possible that all the three economies, of  Countries A,B, and C, are open economies currently? Explain.                        (3 marks)

g)    About Country C, suppose the country’s investment in foreign assets totaled $C2,500 billion and $C2,700 billion at the beginning and the end of this year respectively, and that the foreign countries’ investment in Country C’s assets totaled $C3,200 billion and $C3,150 billion at the beginning and end of this year respectively. Calculate the net capital outflow and net export of Country C for this year.         (6 marks)

Question 2 (25 marks total)

(a) One among the three reasons for the aggregate demand curve to be downward sloping is the so-called exchange-rate effect (as we will learn in Ch 33), which means specifically that there is negative relation between the price level (P) and the net export (NX). Explain the exchange-rate effect using the three-panel diagram for the open economy. Make sure   that all the changes in the loanable fund market, theNCO, and the currency exchange market are clearly stated in your answer.                                 (11 marks)

(b) Country X is rather unique in that it has plenty reserves of a kind of mineral. This kind of mineral was deemed to have little value previously, but now become highly valuable for containing a key ingredient in making a newly invented and much improved kind of power battery. Big firms around the world are in talk with Country X government about possible direct investment in Country X for the extraction and processing of the material; and some are close to a final deal and expect to start their FDI projects in Country X next year. Explain with the aid of a three-panel diagram how Country X will be affected next year by the said events. Indicate in your explanation how the following will change as a result: interest rate, loanable fund saved and invested, net capital outflow, real exchange rate, and net export.                                (14 marks)

Question 3 (27 marks total)

Suppose that the industries of an economy heavily rely on the inputs of agricultural products. The economy is initially in long-run equilibrium. Favorable weather conditions increase the  output of the agricultural sector and reduce firms ’ costs in the short-run.

a)  Use the AS-AD model to illustrate and explain the short-run impact of the change on the  price and output of the economy (assuming no monetary or fiscal policy is in effect in the process). Illustrate your answer in an AD-AS diagram. (6 marks)

b)  How would the economy adjust in the long-run? Use the sticky-wage theory to explain  the adjustment in output and price (assuming no monetary of fiscal policy is in effect in the process). Illustrate your answer in a separate AD-AS diagram.                    (6 marks)

c)   Suppose, alternatively, that the central bank pursues a monetary policy that achieves stable price, i.e., the central bank constantly adjusts the money supply so as to keep the price level unchanged. Answer Part a) again under this alternative assumption. Illustrate your answer in a separate AD-AS diagram.                 (7 marks)

d)  Answer Part b) again under the alternative assumption stated in Part c). Illustrate your answer in a separate AD-AS diagram. Further, do you think such a monetary policy amplifies or dampens the change in real output? Explain based on the diagram drawn for this part.                                   (8 marks)

Question 4 (not for submission, only for Practice)

Suppose the economy currently is in recession, with output lower than the potential level by $400 billion, and the government decides to use expansionary fiscal policy to close the recessionary gap. The people’s marginal propensity to consume (MPC) is estimated to be 0.75.

a)   Suppose the fiscal policy to fight recession is specifically to increase government spending, and suppose there will be no crowding-out effect from such a policy. Should the increase of government spending be $100 billion, more than $100 billion, or less than $100 billion? Explain and show calculations.

b)  How would you modify your answer above if there is crowding-out effect? Explain.

c)  Alternatively, suppose the expansionary fiscal policy adopted is to cut the taxes by $100 billion (with no change to government spending). In the short-run with no change of the price level, how much is the initial effect of the tax cut on aggregate demand (i.e. before there is multiplier effect)? And how much is the total effect on the aggregate demand (i.e. after the multiplier effect)? Show calculations.

d)  Suppose the government spending increase (as the only policy measure) required to end the recession is $120 billion. How much tax cut (as the only policy measure) is needed to end the recession? Show calculations.

e)   In addition to increase in government spending and decrease of taxes, in the toolbox of the government to fight recession is also the expansionary monetary policy. Will the long-run equilibrium restored by these three policy measures respectively be the same in terms of total output (Y), consumption (C), investment (I), and government purchases (G)? Explain.