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Practice Problems

PARTI: MULTIPLE CHOICE


1. The CPI index:
A. Is usually highly correlated with the GDP deflator
B. Measures the price of a consumption basket; the GDP deflator, instead, measures the cost of a
basket of locally produced goods
C. Is sensitive to the high volatility of the price of food and energy
D. All of the above
2. Looking at the composition of GDP in the last 50 years, we can claim that:
A. Both in India and the US the consumption share has been converging to about 70%
B. The investment share has a positive trend in India and negative trend in the US
C. Both US and India are net exporters, and their exports represent a large share of GDP
D. The government expenditure share has declined both in India and the US
3. The desired investment level:
A. increases when either the real rate in the economy or the price of equipment increase
B. decreases if expected productivity increases
C. increases if the Effective Tax Rate increases
D. none of the above.
4. The current negative Net-Exports (NX) in India:
E. Implies that the rest of the world (taken together) has negative NX
F. Is historically the largest component of GDP
G. Helps foreign countries to increase their financial investment in India
H. none of the above
5. Given the following report for the US economy:

A.
B.
C.
D.

US economic growth slowed during the first quarter of 2011 compared to previous quarter.
First quarter growth came in lower than the median projection for 2.0 percent.
Realized inflation was below expectations
All of the above

6. Suppose country X has a current account surplus, which of the following is true?
A. Net foreign wealth (i.e., wealth held by citizens of country X) will tend to increase.
B. Imports will be greater than exports.
C. National savings will be lower than if the country has a current account deficit.
D. All of the above.
7. If a Brazilian company opens a new factory in Peru, it makes
A. a foreign direct investment. The factory will make a bigger impact on Perus
GDP than on its GNP.
B. a foreign direct investment. The factory will make a bigger impact on Perus GNP
than on its GDP.
C. a foreign portfolio investment. The factory will make a bigger impact on Perus
GDP than on its GNP.
D. a foreign portfolio investment. The factory will make a bigger impact on Perus
GNP than on its GDP.
8. Which of the following is a problem with how real GDP is typically measured:
A. Measurements do not account for inflation.
B. It is difficult or impossible to measure black market (illegal) activity.
C. GDP overstates the effects of pollution and other externalities.
D. All of the above.
E. None of the above.
9. Suppose that a Canadian citizen crosses the border each day to work in the United States. Her
income from this job would be counted in
A. U.S. GNP and Canadian GNP.
B. U.S. GNP and Canadian GDP.
C. U.S. GDP and Canadian GNP.
D. U.S. GDP and Canadian GDP.
10. Write an equation that relates the nominal interest rate to the real interest rate and the expected rate
of inflation i = r + e
11. A reduction in the money supply causes the nominal interest rate to
( rise / fall / remain the same ) in the short run and the price level to
( rise / fall / remain the same ) in the long run.
12. Suppose that the money supply is growing at 6%, velocity is constant and output is growing at 4%.
Then according to the quantity equation the inflation rate should be approximately 2 percent.
Simple answer: grows approximately at sum of individual rates, so 6% 4% = 2%
More complex (and accurate) answer: (1.06)=(1.04)(1+x) and solve for x
13. The opportunity cost of holding money rather than bonds is increasing in the nominal interest
rate.
Word nominal is important

14. An increase in money demand tends to ( raise / lower / does not affect ) nominal interest rates.
15. The government budget deficit rises in Malta. Malta is a small open economy. All else equal, net
exports ( rise / fall / remain the same ) and the local currency ( appreciates / depreciates / remains the
same ) in value.
Savings fall so NCO falls so NX fall. Local currency appreciates so NX can fall.
16. An increase in net capital outflows from India will cause the local currency to
( appreciate / depreciate / remain unchanged ) and local net exports to (increase / decline / remain
unchanged)
18. Suppose that PPP holds. Ceteris paribus, deflation (falling prices) in Brazil is accompanied by an (
appreciation / depreciation ) of the Brazilian currency.
19. Investors lose confidence in Russia. One might expect the Russian currency to
( appreciate / depreciate / remain unchanged ) in real terms, and Russian net exports to (increase /
decline / remain unchanged )

PART II:
CURRENT ACCOUNT
Question 1: Suppose that the Indian government increases taxation on foreign investments and for
political reasons stops pushing economic reforms aimed at facilitating financial integration. Suppose
that international investors start to be more concerned about growth and political risk in India. Using
graphs, explain how this will affect investment, real GDP growth, and the current account (savings
minus investment).

r
I

rW + RP

rW + RP

I, S

Answer:
Investors will require a higher premium on investment in India. Given the higher interest rate, there
will be fewer project with positive net present value to implement and domestic investment will decline.
Since investment is an important component of GDP, GDP growth will slow down and capital
accumulation will proceed at lower pace as well.
On the other side, the higher interest rate will promote more national savings and will improve India
net exports, and hence its current account.

Question 2: What are the implications for the capital and financial account? What are the benefits and
the costs?
An improvement in the current account corresponds to a deterioration of the capital and financial
account.
The improvement of the Indian current account implies that external debt will grow at a slower speed
or even decline, as in the case of the graph. Indeed, if the Indian net exports become positive there is
going to be a positive change in Indian net foreign asset position. This is a benefit for India.
On the negative side, there is going to be an outflow of capital from the country. Foreign investors will
stop promoting physical investment in India and Indian resources will be used to promote investments
abroad. This is a potential cost for the Indian economy.

Short answers:
1. Newspaper clip: While some in the United States put the trade deficit down to a failing U.S.
competitiveness or protectionist policies abroad, some economists claim that its genesis lies in the
budget deficit. How would the budget deficit be responsible for the trade deficit? What conclusions
can be drawn about U.S. competitiveness?
One possibility is that the government deficit lowers national savings, thereby putting pressure on the
current account balance (lower domestic savings to finance investment). Net exports may suffer,
interest rates are pushed upwards, and private investment is reduced (crowded out). Since this
channel may bind to some degree, then you can say nothing about the general competitiveness of U.S.
goods and services, only that the budget deficit is distortionary.
2. Suppose that James, a resident of the U.S., buys software from a company in India. Explain briefly
(1) why and (2) in what directions this changes U.S. net exports and U.S. net capital outflow.
This is an import (from the U.S. perspective), so net exports fall. All else equal, there has to be a
counterbalancing financial flow. India accumulates a financial claim against the U.S.
Example Question from popular press:
Please read the attached article and answer two questions below.

Indias lust for gold

Treasure chest
Love of gold becomes a macroeconomic problem

Jan 12th 2013 | MUMBAI | From the print edition, The Economist
THE wardrobe of Datta Phuge, a businessman in Pune, in west India, has a new addition. Weighing
3.25 kilos and costing a quarter of a million dollars, it is a chain-mail shirt made of gold. I always
move around with bodyguards, a glittering Mr Phuge reassured the Pune Mirror. Sadly, Indias gold
obsession is no laughing matter. India is the worlds largest consumer. Surging gold imports have
helped widen the current-account deficit, which was an alarming 5.4% of GDP in the quarter to
September. On January 2nd the finance minister appealed to the nation to buy less gold.
Some argue that Indias gold imports should be reclassified as a capital flow, which would make the
current-account deficit look less scary. But the official fear of gold is rational. Whatever the accounting
treatment, money flowing out of India to buy bullion strains its balance of payments. And wealth
stored in ingots or jewellery rather than bank deposits or shares is unavailable for investment. Indias
household savings rate is high, but as much as half is now squirrelled away in physical form.
Punes wide boys aside, the traditional gold consumers are southern peasants buying jewellery. They
have no access to formal finance; gold requires no paperwork, incurs no tax and is liquid. But over the
past decade the mania has spread. By weight consumption has doubled, for several reasons: a surge in
money earned on the black market; investors chasing the gold price; and the dismal returns savers get
from deposit accounts. Real interest rates are low, reflecting high inflation and a repressed financial

system that is geared to helping the state finance itself.


India has tried coercion. Between 1947 and 1966 it banned gold imports. After that it used a licensing
system. Neither worked. Smuggling soared and policymakers were reduced to tinkering with airportbaggage allowances. By 1997 trade was liberalised.
If bullying doesnt work, what can be done? One option is dematerialisationcreating gold-linked
products that are not fully backed by imported bullion. The risk is that the firms selling them are then
exposed to a swing in the gold price or, if they try to hedge this risk, to derivative contracts with
counterparties.
A better alternative is to try to monetise gold by encouraging more people to use it as collateral
against which they can borrow. Such loans have been booming but are still probably worth just 1.5% of
GDP. By contrast, the stock of gold held by Indians may be as much as 50%.
The best bet of all would be a freer financial system that reaches more people and offers higher returns.
Just dont bet on its arriving soon. Mr Phuge, for one, is awaiting delivery of his next investmenta
gold mobile phone.

Question 1: (15pts) The article above states that


Whatever the accounting treatment, money flowing out of India to buy bullion strains its balance of
payments.

What does this statement mean? Using our graphical analysis, show what the impact of
gold imports does to the savings-investment equilibrium (For simplicity, hold the global
interest rate constant throughout the analysis of this first question). Show what the
capital market equilibrium would look like if Indian demand for foreign produced gold
indeed fell. How would this impact the inflow/outflow of financial capital?
Answer: Under the current situation, Imports > Exports so NX < 0, with gold imports contributing to Indias current
account deficit. This condition is also equivalent to saying that I > S, i.e., domestic investment exceeds domestic savings.
In this case, other countries must finance Indias current account deficit, thereby necessarily accumulating claims against
future Indian output (balance of payments means this). A reduction in gold purchases lowers imports and, defined in this
way, consumption (thereby, increasing domestic savings). Holding global interest rates fixed, the trade deficit narrows,
and less global investment in India is required.

r
Snew

rw
Id
S, Id
6

Question 2: (10pts) The article also states that


And wealth stored in ingots or jewellery rather than bank deposits or shares is unavailable for
investment. Indias household savings rate is high, but as much as half is now squirrelled away in
physical form.

Given Indias savings rates defined in this way, through both financial savings and gold
imports, explain the implications for investment, interest rates, and long-run growth.
[India is an open economy, but not small in the way we defined it in class].
Answer: India is open, but not small. More limited supplies of loanable funds not only affect the trade deficit, but also
generate higher interest rates and lower quantities of desired investment. Fewer high MPK investments are not necessarily
financed. Long-run growth is slower than it should otherwise be.