Economics 110B

Solutions to Practice Questions for Chapter 20

1. Focus on the market in which dollars are traded for Japanese yen. Consider a graph in which the
vertical axis represents the number of yen needed to purchase a dollar, and the horizontal axis shows
the number of dollars being traded in the yen-dollar market. The supply for dollars on that graph is
upward sloping. Explain why the supply of dollars is positively sloped.
Answer: Consider the market in which dollars and yens are traded. The supply of dollars in the
foreign exchange market is positively sloped, which means that the quantity supplied of dollars in this
foreign exchange market increases with E (units of yen needed to purchase a dollar). Why? At given
prices for Japanese goods, services and assets, the more yen a dollar can buy, the cheaper those
goods, services or assets are in dollar terms. Therefore, more Japanese goods, services and assets will
be demanded by holders of dollars, hence the greater will be the supply of dollars in the yen-dollar
market.

m
er as
co
2. How would each of the following be likely to affect the value of the dollar, all else being equal?

eH w
a. US stocks are perceived as having become much riskier financial investments.
Answer: When U.S. stocks are perceived to be riskier financial investments, American assets

o.
become less attractive to investors, including foreign investors. So, the demand for dollars
rs e
falls (Demand for dollars curve shifts down and to the left), and the dollar depreciates.
ou urc
b. European computer firms switch from US-produced software to software produced in India,
Israel and other nations.
Answer: When European computer firms switch from U.S.-produced software to software
o

produced in India, Israel, and other nations, the demand for U.S. goods (software) falls, so the
demand for dollars falls. The dollar depreciates.
aC s

c. As East Asian economies grow, international financial investors become aware of many new
vi y re

high-return investment opportunities in the region.

Answer: When international investors become aware of new, high-return investment
opportunities in East Asia, financial investors will switch funds from American assets to East
Asian assets and thus they will supply more dollars to the foreign exchange market (in
ed d

exchange for East Asian currencies.) The dollar depreciates.

ar stu

3. Explain why the law of one price may not hold for some classes of goods.
Answer: The law of one price states that prices of the same good will be identical in different
countries. However, a requirement for this to occur is for goods to be traded so that arbitrage
sh is

conditions exist. Goods that are not traded cannot take advantage of arbitrage conditions and therefore
Th

are unlikely to converge to the same price. Even goods that are identical may not converge to the
same price (e.g. the Big Mac) because of the local nontraded input price differences (labor, rent,
transportation).

4. The Great Recession forced the European Central Bank to lower interest rates in the euro area. Using
our short-run model, what is the predicted impact of that policy on the US economy?
Answer: When interest rates are included in the net exports function in our model, we have
NX t
Yt
( )
= a nx + bnx R w − r − bnx ( Rt − r ) , so initially R w ↓ , reducing net exports ( NX ↓). For the same level

of real interest rate, short-run output is now lower. IS curve shifts to the left. AD ( Y˜ = a − b ( π − π ) )
t t

also shifts down and to the left ( a ↓). Short-run output and inflation decline. The adjustment to the
€ €
€ long run would then follow the opposite dynamics from Figure 20.5 in the textbook.
€
€
https://www.coursehero.com/file/13073252/Problem-Set-Chpt20-Solutions/
 5. Consider a short run model whereby
(1) Ct = ac Yt
(2) It = aiYt − bi ( Rt − r )Yt
(3) Gt = ag Yt
(4)€ (
NXt = anx Yt − bnx Rt − R w Yt )
€w
and R is the real interest rate (taken exogenously) in the rest of the world. All other variables with
€usual exogenous parameters. Rt is the domestic real interest rate and r the rate of return on
bars are
capital.
€
€
a. Explain the rationale behind the specification of NX in (4).
€
Answer: If bnx > 0 , €the specification suggests that net exports are negatively related to the  
domestic interest rate and positively related to the world interest rate. This makes sense if you  
consider how changes in the relative rates of return of financial assets abroad and
domestically influence the flows   of investment capital, and the nominal and real exchange

m
€

er as
rate. As the domestic interest rate Rt   increases, domestic assets become more attractive
relative to foreign ones, so foreign investors will go to the foreign exchange market to trade

co
eH w
their currencies for dollars, shifting the demand curve for dollars to the right, putting upward  
pressure on the nominal exchange
€ rate. In the short run, the movements on the nominal

o.
exchange rate are reflected in the real exchange rate. Real exchange rate increases, meaning
rs e
that domestic goods and services are relatively more expensive, and net exports reduce. On
ou urc
the other hand, an increase in R w   has exactly the opposite effect. As interest rate abroad
increases, foreign assets become more attractive to investors. American investors will go to
the foreign exchange market to change their dollars for foreign currency, increasing the
o

supply of dollars (supply

€ of dollars shifts to the right) and decreasing the nominal (and real)
exchange rate. As real exchange rate decreases, American goods and services are cheaper
aC s

relative to foreign goods, and hence exports increase and imports increase. The result as that
vi y re

NX increase.
( )
b. Rewrite NXt as NXt = a nx Yt + bnx R w − r Yt − bnx ( Rt − r )Yt and derive the IS curve for this
model by solving for short run output Y˜ as a function of the real interest rate, R .
ed d

t t
Answer: By adding the term Ytbnx r − Ytbnx r  to the right hand side (note that the term is  
ar stu

equal to€0 so this is a legal maneuver), we can regroup terms and re‐write
( )
NX t = a nx Yt − bnx Rt − R w Yt€ ( )
 as NXt = a nx Yt + bnx R w − r Yt − bnx ( Rt −€r )Yt
€ we will
To derive the IS curve,
sh is

i) add up the components (1)‐(4) above

ii) divide through by Yt  
Th

€ €
iii) subtract 1 (to get everything in terms of cyclical output, Y˜t  
which yields:
Y˜t = a c + a i +€a g + a nx − 1 + bnx ( R w − r ) − (bi + bnx )( Rt − r )  
Which could be interpreted as €
˜
Yt = a − b ( Rt − r )  
€ c. How will an increase in the real interest rate abroad affect the IS curve? Explain.
Answer: An increase in R w  increases the intercept term, a in Y˜t = a − b ( Rt − r ) . That causes
€ the IS curve to shift upward/rightward. This happens because an increase in the real interest
rate abroad makes foreign assets more attractive, putting downward pressure on the real
exchange rate and € increasing net exports (and hence,
€ output)
€ at every level of the domestic

https://www.coursehero.com/file/13073252/Problem-Set-Chpt20-Solutions/
 interest rate.
d. Suppose that a fervor of nationalism changes preferences towards purchasing more domestic
goods relative to foreign goods resulting in anx increasing and staying at that higher level   for
two periods (beginning in period 1). Use the AS/AD framework to explain what will happen
over time as the economy is moved away from its steady state (assume it started in the steady
state in period zero) and transitions back towards it after the shock to net exports.
Answer: A shock to the net exports € can be interpreted as a shock to the parameter, a  in our
aggregate demand curve equation, Y˜t = a − b m ( π t − π ) . This means that short run output has
increased for every value of the inflation rate so that (1) the aggregate demand curve has
shifted up and to the right causing output to initially increase with inflation.€ This causes
upward inflationary pressure€ pushing up expected inflation, causing the supply curve to (2)
begin to shift upwards over time. After two periods, the demand curve (3) shifts back left
towards its original position, (4) pulling the supply curve back down with it. The dynamics
look similar to what happens in the situation in Figure 13.15.

m
er as
Assess the validity of each of the following statements. Explain briefly.

co
eH w
6. Given the definition of the exchange rate adopted in this course, if the dollar is the domestic currency

o.
and the euro the foreign currency, a nominal exchange rate of 0.75 means that 0.75 dollars is worth
0.75 euros. rs e
ou urc
Answer: False. A nominal exchange rate of 0.75 means that 1 dollar is worth 0.75 euros.
o

7. A real appreciation means that domestic goods become less expensive relative to foreign goods.
aC s

Answer: False. The real exchange rate is the price of domestic goods relative to the price of foreign
vi y re

goods. If the real exchange rate increases (real appreciation) then domestic goods become more
expensive relative to foreign goods.
ed d

8. Buying at a low price in one country to sell at a higher price somewhere else to make a profit is called
the law of one price.
ar stu

Answer: False. It is called arbitrage. The presence of arbitrage implies that prices for the same good
will tend to equate in the long run.
sh is

9. If the law of one price holds for all goods, and the quantity theory of money determines long-run
Th

price level, we can pin down the long-run level of the exchange rate.
Answer: True. Using the law of one price and the quantity theory yields the equilibrium nominal
exchange rate in the long run.

10. The US dollar would appreciate if nominal interest rate in the US increased.
Answer: True. If the US interest rate rises, US assets earn higher returns and will attract investors,
including foreign investors. The demand for dollar rises and as such the price of the dollar increases
(US dollar appreciates).

https://www.coursehero.com/file/13073252/Problem-Set-Chpt20-Solutions/

Powered by TCPDF (www.tcpdf.org)