METU Department of Economics

ECON 354
Instructor: Elif Akbostancı

PROBLEM SET 4 (CHAPTER 23)

1) Under a gold standard, countries may adopt excessively contractionary monetary
policies as all countries compete for a larger share of the limited supply of world gold
reserves. Can the same problem arise under a reserve currency standard when bonds
denominated in different currencies are all perfect substitutes?
A monetary contraction, under the gold standard, will lead to an increase in the gold
holdings of the contracting country’s central bank if other countries do not pursue a
similar policy. All countries cannot succeed in doing this simultaneously since the
total stock of gold reserves is fixed in the short run. Under a reserve currency system,
however, a monetary contraction causes an incipient rise in the domestic interest rate,
which attracts foreign capital. The central bank must accommodate the inflow of
foreign capital to preserve the exchange rate parity. There is thus an increase in the
central bank’s holdings of foreign reserves equal to the fall in its holdings of domestic
assets. There is no obstacle to a simultaneous increase in reserves by all central banks
because central banks acquire more claims on the reserve currency country while their
citizens end up with correspondingly greater liabilities.
2) The foreign exchange market and the demand for imported goods are given below for
Turkey and US:

a)

TURKEY
e (TL/$) e ($/TL) PUS PTR QD-TR QD($)-TR QS(TL)-TR
2.0 0.5 $20 40 75 units $1500 3000
1.5 0.67 $20 30 110 units $2200 3300
1.0 1 $20 20 175 units $3500 3500
US
e ($/TL) e (TL/$) PTR PUS QD-US QD(TL)-US QS($)-US
0.5 2.0 40 TL $20 100 units 4000 $2000
 0.67 1.5 40 $26.8 70 units 2800 $1876
1 1.0 40 $40 40 units 1600 $1600

b) Stable market
Whenever there is disequilibrium in the market, this cannot be permanent; there will
be an immediate movement to equilibrium.

QD-US QD(TL)-US QS($)-US

100 units 4000 $2000
185 units 7400 $4958
60 units 2400 $2400
c) Stable market.

d) 1st case: Q1 = 100, Q2 = 70

P1 = 20 P2 = $26.8

Arc elasticity = (-30 /170)/ (6.8/ 46.8) = 1.214 (US price elasticity of demand for
Turkish goods.) So demand is elastic.

2nd case: Q1 = 70, Q2 = 40

P1 = 26.8 P2 = $40

Arc elasticity = (-30 /110)/ (13.2/ 66.8) = 1.38

So, demand is elastic.

3) What is the relationship between PPP and exchange rate pass through?

Exchange rate pass-through (EPT) is the rate at which import prices are changing in
response to a change in the exchange rate i.e. EPT (ε PT)=(% ∆ in PM)/(% ∆ in e). If EPT is
complete than εPT =1 which means that all the changes in the exchange rate will be reflected in
the import prices (PM). Assuming that the general price level P consists of mainly traded goods
prices then % ∆ in PM=% ∆ in P. In this respect PPP states that e=P/P* Therefore as PPP tends to
hold perfectly when EPT is complete. But if EPT is incomplete or at the extreme there is no EPT
than PPP tends to not hold.

4) Suppose that both the supply curve of imports to country A and the supply curve of
exports from country A are horizontal. Assume that at a pre-depreciation value of A’s
currency, country A sells 975 units of exports and purchases 810 units of imports and
trade is initially balanced. Suppose now that there is a 10 percent depreciation of A’s
currency against foreign currencies and that because of the depreciation exports rise to
1025 units and imports fall to 790 units. Would the simple Marshall-Lerner condition
suggest that country A’s current5 account balance has improved or deteriorated because
of this depreciation of its currency?
According to the Marshall-Lerner condition, the current account balance will improve
because of currency depreciation if the sum of the absolute values of the elasticities of
demand for imports and exports is greater than 1.0. In this problem the elasticity of
demand for imports is equal to {(790 - 810)/[(790 + 810)/2]}/0.10 = - 0.25. The
elasticity of demand for exports is equal to {(1025 - 975)/[(1025 + 975)/2]}/(-0.10) = -
0.50. The sum of the absolute values of these two elasticities is thus 0.75, which is
strictly less than 1.0. One would therefore conclude that a depreciation of the home
currency would cause the current account balance to worsen
5) What is the difference between stable market equilibrium and unstable market
equilibrium? Will a downward sloping supply curve always produce market stability?
Why or why not?
Market stability occurs when the characteristics of supply and demand are such that
any price deviation away from equilibrium sets in motion forces that move the market
back toward equilibrium. A price that is too low creates an excess demand, causing
consumers to bid up the price until supply again equals demand and excess demand is
removed. Similarly, a price that is too high creates an excess supply causing producers
to begin lowering price until supply again equals demand.
In the unstable market example, backward sloping supply curve is flatter than the
demand curve. A price below the equilibrium price leads to excess supply and a price
 above the equilibrium price leads to excess demand. Since the excess demand leads to
increase in price and excess supply leads to decreases in price, any movement away
from equilibrium sets in motion forces leading to further movements away from
equilibrium. However, a downward supply curve does not always mean an unstable
market. In case of backward sloping supply curve steeper than demand curve, any
price deviation away from equilibrium sets in motion forces that move the market back
toward equilibrium.
6) What will happen in an unstable market if the domestic currency depreciates? Explain
how this could occur?
An unstable FX market requires that the supply is downward sloping and demand
curve is steep so that the slope of the supply curve is lower (in absolute value terms)
than the demand curve. In a market like this suppose that an economy has current
account deficit, then an increase in the exchange rate will lead to a larger current
account deficit. These types of markets are expected to occur in the short run, where
there are lags in the production response of exports and demand for imports are not
responsive due to contracts, therefore the supply and demand elasticities are probably
low so that Marshall-Lerner condition does not hold in the SR. As time passes by, as
move towards long-run elasticities get larger and both exports and imports start to
adjust to the exchange rate depreciation. Thus the FX demand and supply curves take
their usual shapes. As this adjustment takes place, the current account deficit will
begin to decline.
7) You observe that a country's currency depreciates but its current account worsens at the
same time. What data might you look at to decide whether you are witnessing a J-
curve effect? What other macroeconomic change might bring about a currency
depreciation coupled with a deterioration of the current account?
A depreciated currency means that imports are more expensive and domestically
produced goods and exports are less expensive. A depreciated currency lowers the
price of exports relative to the price of imports. On the other hand, a country’s current
account is the balance of trade between a country and its trading partners, reflecting all
payments between countries for goods, services, interest and dividends. So, a
depreciated currency in a country which makes imports expensive leads to current
 account deficit i.e. the country is spending more on foreign trade. A J-curve effect is
witnessed when a country's trade balance initially worsens following a devaluation or
depreciation of its currency. For this we look at the exchange rate because, the higher
exchange rate will at first correspond to costlier imports and less valuable exports,
leading to a bigger initial deficit.
Other macroeconomic factors or changes that might bring about a currency
depreciation coupled with a deterioration of the current account might be high fiscal
deficit or high inflation. A country experiencing higher inflation will face decrease in
purchasing power of that country’s currency against the other currencies. It leads to
worsening of capital outflows and eventual depreciation of currency which is
associated with the current account deficit.
8) Answer each as True, False, or Uncertain, providing explanation
a. A real depreciation always improves the trade balance.
False. In theory, if the Marshall-Lerner condition does not hold, a real
depreciation can lead to a decrease in net exports. In reality, the effect of the
depreciation is rejected much more in prices than in quantity initially. Thus, the
trade balance deteriorates first and then improves gradually. (See the J-Curve)
b. An increase in exports (due for example to an increase in foreign output)
increases imports.
True. An increase in foreign demand for domestic goods increases exports
directly, which leads to a higher level of domestic output. Higher domestic
income increases imports, as the latter depends on domestic output positively.
Note that the increase in exports is still higher than the increase in imports, and
the trade balance still improves.
c. Governments should avoid trade deficits as they always lead to an outflow of
foreign capital.
False. All else equal, trade deficit implies a lower current account. We know
that a lower current account means a higher capital account, which means an
inflow of foreign capital, instead of an outflow of foreign capital.
P
d. Assume that the Marshall-Lerner condition holds and ¿ =1 so that real and
P
nominal exchange rates are the same. In the short run, in an open economy,
with flexible exchange rates and constant expectations about the future
exchange rate, an expansionary monetary policy has an ambiguous effect on
trade balance.
True. Net exports depend on domestic output, foreign output, and the exchange
rate: NX = NX (Y, Y*, e). An expansionary monetary policy leads to an
increase in output Y and a depreciation of e (from the monetary and portfolio
balance models). The first effect decreases next exports, while the second
effect increases NX, given that the Marshall-Lerner condition holds. The
overall effect is ambiguous.