Answers

1.
A.“Long run” means that prices of goods and services, and of the factors of
production that build those goods and services, adjust to supply and demand
conditions so that their markets and the money market all reflect full
employment.Because prices are allowed to change, they will influence interest rates
and exchange rates in the long run models.
B. The law of one price simply says that the same good in different competitive
markets must sell for the same price, when transportation costs and barriers between
markets are not important.People would have an incentive to adjust their behavior and
prices would tend to adjust to reflect this changed behavior until a single, uniform
price is achieved across markets
C.purchasing power parity that has already been discussed. Exchange rates equal
price levels across countries.
E$/€ = PUS/PEU

D.changes in exchange rates equal changes in prices (inflation) between two periods:
(E$/€,t - E$/€, t –1)/E$/€, t –1 = πUS, t - πEU, t
where πt = inflation rate from period t-1 to t
(Absolute implies relative.)
E. The flexible-price monetary model assumes that prices of goods are flexible, and
that purchasing power parity (PPP) always holds. The assumption about PPP implies
that the real exchange rate is constant over time
2.
A. Balance Of Payment (BOP) is a statement that records all the monetary
transactions made between residents of a country and the rest of the world during any
given period. This statement includes all the transactions made by/to individuals,
corporates and the government and helps in monitoring the flow of funds to develop
the economy.
B. There are three components of the balance of payment viz current account, capital
account, and financial account. The total of the current account must balance with the
total of capital and financial accounts in ideal situations.
Current Account
The current account monitors the inflow and outflow of goods and services between
countries.
Capital Account
All capital transactions between the countries are monitored through the capital
account. Capital transactions include purchasing and selling assets (non-financial) like
land and properties.
Financial Account
The flow of funds from and to foreign countries through various investments in real
estate, business ventures, foreign direct investments etc., is monitored through the
financial account.
A disequilibrium in the balance of payment means its condition of Surplus Or deficit.
A Surplus in the BOP occurs when Total Receipts exceeds total payments. Thus,
BOP= CREDIT>DEBIT. A deficit in the BOP occurs when total payments exceeds
total receipts. Thus, BOP= CREDIT<DEBIT.
C. A) Non- Monetary measures
 Export Promotion
 Import Substitutes
 Import Control
B)Monetary Measures
 Exchange Control
 Deflation
 Devaluation
 Exchange Rate Depreciation
 Fiscal Policy
 Monetary Policy
D. The Current account on the Balance of payments measures the balance of trade in
goods and services. in a closed economy, we assume that saving = investment. (S=I).
For a firm to invest, it needs savings to be able to finance the investment. See: Saving
and investment.
(C= consumption, I= Investment, G=government spending) (X-M) = net demand from
abroad.) Therefore, CA = GNP – (C+I+G)
3.
A. Equilibrium in the market for goods and services occurs when the aggregate
demand for goods and services, defined as Yd = Cd + Id + G0, is equal to the
aggregate supply of goods and services, Y. Hence in goods market equilibrium Yd =
Y =Cd + Id + G0.
B. The market balance of payments refers to the balance of supply and demand for a
country's currency in the foreign-exchange market at a given rate of exchange. If the
exchange rate is fixed, the market balance of payments would be in balance only by
chance.A change in a country's balance of payments can cause fluctuations in the
exchange rate between its currency and foreign currencies. The reverse is also true
when a fluctuation in relative currency strength can alter balance of payments.
C. If a country adopts a fixed exchange rate policy, the exchange rate is the target of
monetary policy. Monetary policy cannot pursue an inflation target or an output target
at the same time as it pursues an exchange rate target. Nor can it set either interest
rates or money supply growth rates independently.
Fiscal policy is potentially an important stabilization policy under fixed exchange
rates. It helps to compensate for the fact that monetary policy can no longer be used.
Automatic fiscal stabilizers play this role. Discretionary changes in government
spending or taxes are useful only if fiscal policy can react quickly to temporary
shocks.
D. With flexible exchange rates monetary policy is powerful for changing AD. It
works through both interest rate and exchange rate linkages in the transmission
mechanism, not just the interest rate linkages of the closed economy. By contrast, the
effects of fiscal policy on aggregate demand are reduced.
4.
A. In a fixed or pegged exchange rate, the central bank doesn’t allow the value of the
national currency to deviate relative to foreign currencies, and will intervene in
foreign markets to stabilize price. Professor Sachs explains aggregate demand through
fiscal expansion or government spending, and then talks about how currencies operate
when they are pegged using the IS-LM model. Monetary policy is highly effective
under the floating exchange rate system, and fiscal policy is effective under a fixed
exchange rate. Sachs talks about how a currency interacts with other currencies in the
international market. In all of these examples, there is an assumption that there is a
high degree of capital mobility between the home financial system and the
international markets, but there can be capital controls.We consider first a fixed
exchange rate system. The AD curve in a closed economy is downward sloping
because a reduction in prices, for a given nominal money supply, means an increased
real money supply. With more real money there will be lower interest rates and more
spending.
B. There are two ways to manage the exchange rates of a country, namely by supply
and demand, or by the central bank setting the price. This is explained using the case
of exchange rate of Renminbi to the US dollar, as managed by the People’s Bank of
China. Countries have the right under international principles to allow their currencies
to fluctuate or to decide that they’re going to stabilize the value of their currency with
respect to another currency (in the case of a floating or fixed exchange rate). Sachs
also talks about how the exchange rate system affects monetary and fiscal
policy.Exchange Rates: When a country's exchange rate increases, then net exports
will decrease and aggregate expenditure will go down at all prices. This means that
AD will decrease.
4.
A. The international monetary system has gone through four stages in its evolution: (1)
the gold standard (1880–1914); (2) the gold-exchange standard (1925–1933); (3) the
Bretton Woods system (1944–1971); and (4) the Jamaica system, also known as the
floating exchange rate system (1976–present).Over the past 75 years, the International
Monetary System has been modified according to the prevailing conditions. The
scope has evolved over the years, but the purpose of the system has remained
constant.
Bretton Woods System
The period after World War 2 gave birth to Bretton Woods System. This monetary
system was in existence from 1945 to 1972. Representatives from 44 countries, in the
year 1944, met at Bretton Woods of the United States and came up with a new
International Monetary System. The focus of the Bretton Woods Agreement was to
establish a uniform and liberal International Financial Architecture with independence
on domestic policies. This agreement gave birth to the US Dollar-based Monetary
System or Gold-Exchange Standard. This system gave birth to the pegging of
domestic currency in terms of US Dollars. A price of $35 was set for 1 ounce of
gold—the countries, rather than linking their currency to the gold-linked it to US
Dollars.
All the member countries of Bretton Woods had to maintain their currencies value
within 1% upward or downward variations in comparison to Fixed Exchange Rate.
This agreement also allowed the Governments of the country to convert their gold
into the US Dollar at any point in time. Eventually, countries and businesses have
started ignoring the link between US Dollar and Gold and have started considering
exchange rates directly.
If the situation prevailed, then Bretton Woods Agreement allowed the country to
devalue its currency by more than 10% straight. Although, it didn’t allow countries to
use this mechanism to benefit from imports and exports of the country.
Downfall of the Bretton Woods System
Post-World War situation, the supply of US Dollars suddenly increased in the world
economy. As a result of it, many countries started questioning the quantum of gold
reserves of the US Government with the supply of the US Dollar. By 1973, many
countries started losing confidence in the US Dollar and started searching for some
other reliable sources.
B. There are four main types of exchange rate regimes: freely floating, fixed,
pegged (also known as adjustable peg, crawling peg, basket peg, or target
zone or bands ), and managed float. Within these four systems there are modified or
intermediate regimes, such as currency board, dollarization, and monetary
union regimes.
FREELY FLOATING EXCHANGE RATE
A freely (clean) floating (or flexible) exchange rate regime, where the monetary
authorities refuse any intervention in the exchange rate market, is the simplest type of
system.
FIXED EXCHANGE RATE
In a fixed exchange rate regime, exchange rates are held constant or allowed to
fluctuate within very narrow boundaries, perhaps 1 percent above or below the initial
set of rates.
PEGGED EXCHANGE RATE
Countries operating under a pegged exchange rate regime “peg” their currency’s
value to a foreign currency or some unit of account (e.g., gold, the European currency
unit, etc.).
MANAGED FLOAT EXCHANGE RATE
In a managed float (or dirty float) exchange rate regime, the monetary authority
influences the movements of the exchange rate through active intervention in the
foreign market without specifying, or recommitting to, a preannounced path for the
exchange rate.
OTHER EXCHANGE RATE SYSTEMS
The currency board is a type of fixed regime, but it is more restrictive and also
includes a requirement for minimum domestic reserves in foreign currency and a
monetary institution that issues notes and coins fully backed by a foreign reserve
currency and convertible into the reserve currency at a fixed exchange rate.
C. External debt is the portion of a country's debt that is borrowed from foreign
lenders through commercial banks, governments, or international financial
institutions. If a country cannot repay its external debt, it faces a debt crisis. If a
nation fails to repay its external debt, it is said to be in sovereign default.High foreign
debt hampers the development of these countries because the money has to be used
for interest and principal payments and is not, therefore, available for key investments,
such as infrastructure or social spending.
By the end of 2019, this pile of so-called external debt rose to $5.6 trillion (€5.28
trillion) in emerging economies, a study by the Financial Stability Board found. And
as a result of the global pandemic, their sovereign debt in total saw the fastest annual
increase in 2020 in the past three decades.
Any 1% increase in the external debt ratio induces an increase in the HDI of 0.02%.
However, above the debt threshold, external debt becomes detrimental to human
development since HDI decreases by 0.01% when external debt ratio increases by 1%.
D. Foreign borrowing has two potential benefits for a developing country. It can
promote growth, and it can help an economy to adjust to internal and external shocks.
However, recent experience has graphically illustrated that borrowing also has
potential disadvantages. It can be wasted on inefficient investment. It can allow a
government to delay essential economic reforms. And the accumulation of debt can
make an economy more vulnerable to financial pressures from the world economy.
How can a developing.
A variety of factors can be seen as having led to the African debt crisis. High among
these is over borrowing. Most developing countries, including those in Africa, face a
shortage of capital, and there is a strong presumption that foreign savings can and
should be utilized to augment the stock of capital over and above what could be
provided by domestic saving. This presumption implies that the typical developing
country should be a net foreign borrower. The addition to the stock of external debt
over time must contribute to growth and development, and in particular to the
country's ability to make payments to creditors. This is the fundamental relationship
underlying the notion of "sustainability" of the stock of foreign debt.
The issue, in other words, is not whether a developing country should borrow abroad,
but how much it should borrow. For this, theory offers some insights and an
understanding as to how the over borrowing occurred. The analytical framework of
the "growth-with-debt" literature, for example, provides a way of determining debt
capacity and optimal foreign borrowing. The standard model used for this purpose
contains two building blocks. The first of these is a growth relationship in which
domestic real output is assumed to depend on factors of production, such as capital,
labour, and imported inputs, and on total factor productivity. For simplicity, one can
make domestic output (q) a function only of the domestic capital stock.