Economics 2203---- Intermediate Macroeconomics I Lakehead University

Fall 2003 Hamza Ali Malik

Test # 2

This test comprises of 8 short questions and 2 long questions. You are required to answer any six of the short questions and both the long questions in the 80-minute exam time. The short questions are worth 4 marks each and the long questions are worth 16 marks, for a total of 40 marks. Short Questions 1)- If a country has a current account deficit, is it a net lender or borrower to the rest of the world? Is the country experiencing net capital inflows or outflows? Should a country necessarily be concerned if it experiences a current account deficit? 2)- Suppose the 1-year interest rate on British pounds is 10 percent, the Canadian dollar interest rate is 15 percent, and the current $/₤ exchange rate is $2.00. Using the concept of uncovered interest parity calculate the expected future exchange rate? Is the exchange rate expected to depreciate or appreciate?

3)- The Marshall-Lerner condition says that a depreciation in the real exchange rate improves the trade balance of a country. Briefly explain the channels through which this effect would take place. 4)- What does a J-curve refer to? Why does the curve have this particular shape? 5)- It is often argued that budget deficits cause trade deficits. Do you agree? Use an open economy goods market equilibrium condition to explain your answer. 6)- “Monetary policy is more effective in terms of influencing aggregate output in a closed economy than in an open economy with flexible exchange rates”. Do you agree with this statement? Briefly explain your reasoning. 7)- Is the open economy IS-curve steeper or flatter as compared to the closed economy IS-curve? How would this change the effectiveness of fiscal policy? Explain your intuition in words. 8) Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument. In other words, the monetary policy becomes the exchange rate policy. Explain the mechanics of this policy.

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Long Questions 1)- In the open economy IS-LM model (the Mundell-Fleming model), with flexible exchange rates, explain what happens to aggregate income, consumption, investment, the exchange rate, and the trade balance when: a)- the money supply is reduced, say, in order to control inflation. b)- taxes are raised to reduce budget deficits. What would happen if exchange rates were fixed rather than flexible? 2)- Suppose that the price level relevant for money demand includes the price of imported goods and that the price of imported goods depends on the exchange rate. That is, the money market is described by

)(. iLYPM

=

where EPPP fd .)1( λλ −+= The parameter λ is the share of domestic goods in the overall price index P. Assume that the price of domestic goods dP and the price of foreign goods measured in foreign currency fP are fixed and equal to one. The goods market remains unchanged and is described as follows: ),,(),()( EYYNXGiYITYCY ∗+++−= Draw the open economy IS and LM curves carefully mentioning the shift variables and analyze the policies described in 1(a) and 1(b) above under flexible exchange rate. (Note: it will be helpful to draw only one graph in Yi − space for each case) Contrast the results in the standard Mundell-Fleming model (question 1) and the modified Mundell-Fleming model (question 2).

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