b. a strike in france leads to a reduction in french …...solutions chapter 7(18) output, exchange...

b. A strike in France leads to a reduction in French income.

Answer: This is an idiosyncratic shock to France’s output (from a reduction in la-bor production). France can buffer the effects on income through borrowing fromthe Czech Republic. France experiences a decline in output (from the labor stop-page), but still continues to enjoy its previous level of consumption and investmentby borrowing from the Czech Republic. France will run a trade deficit that canfinance France’s GNE. Likewise, the Czech Republic’s output is relatively high(compared with France), so its GDP > GNE, with the difference flowing toFrance in the form of net exports.

c. Floods destroy a portion of the Czech capital stock, lowering Czech income.

Answer: This is a negative idiosyncratic shock to the Czech Republic. TheCzech Republic can run a trade deficit and borrow from France, buffering itsGNE against the shock. Once the Czech Republic recovers it can run trade sur-pluses and pay back its loans from France.

10. Assume that a country produces an output Q of 50 every year. The world interest rateis 10%. Consumption C is 50 every year, and I � G � 0. There is an unexpected dropin output in year 0, so output falls to 39 and is then expected to return to 50 in everyfuture year. If the country desires to smooth consumption, how much should it bor-row in period 0? What will the new level of consumption be from then on?

Answer: There is a one-time decrease in output of 11 units. Therefore, the presentvalue of consumption is:

PV(C) � PV(Q) � PV(G) � 39 � �05.100

� � 539

To determine the level of consumption each period, we know that the country wantsto maintain a given level of consumption:

PV(C) � C � �Cr*

�

539 � C � �0.C10� therefore C � 49

Since the output drops to 39 in the year 0, the country must borrow 10 units to con-sume 49 units. Note that for every 10 units borrowed, consumption is reduced byone unit, as NFIA � 0.10 10 in subsequent periods. Therefore, C � 49 in period0 and thereafter. Alternatively, the change in consumption can be calculated using thefollowing:

�C � �1 �

r*r*

� �Q � �1 �

0.100.10

�(�11) � �1

Consumption decreases by one unit, to C � 49.

11. Assume that a country produces an output Q of 50 every year. The world interest rateis 10%. Consumption C is 50 every year, and I � G � 0. There is an unexpected warin year 0, which costs 11 units and is predicted to last one year. If the country desiresto smooth consumption, how much should it borrow in period 0? What will the newlevel of consumption be from then on?

The country wakes up in year 1 and discovers that the war is still going on and willeat up another 11 units of expenditure in year 1. If the country still desires to smoothconsumption looking forward from year 1, how much should it borrow in period 1?What will be the new level of consumption be from then on?

Answer: If the war is temporary, the increase in G should be financed through bor-rowing (e.g., running a current account deficit). To determine how much the countryshould borrow, we first must calculate the change in the present value of consumption.

Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-55

The present value of government spending is equal to 11, as this is a one-time increasein government spending. Therefore, the present value of consumption is:

PV(C) � PV(Q) � PV(G) � 50 � �05.100

� � 11 � 539

To determine the level of consumption each period, we know that the country wantsto maintain a given level of consumption:

PV(C) � C � �Cr*

�

539 � C � �0.C10� therefore C � 49

To consume 49 units, along with the war expenditure of 11 units, the country needsto borrow 10 units.

If the government needs to borrow again, then we can use the same approach to findconsumption each period. Note that for every 10 units borrowed, consumption is re-duced by one unit, as NFIA � 0.10 10 in subsequent periods. Therefore, in pe-riod 0, C � 49. Thereafter, when the government needs another 11 units, beginningin period 1, C � 48 (as NFIA increases by one additional unit).

12. Consider a world of two countries, Highland (H) and Lowland (L). Each country hasan average output of 9 and desires to smooth consumption. All income takes the formof capital income and is fully consumed each period.

a. Initially, there are two states of the world: Pestilence (P) and Flood (F). Each hap-pens with 50% probability. Pestilence affects Highland and lowers the output thereto 8, leaving Lowland unaffected with an output of 10. Flood affects Lowland andlowers the output there to 8, leaving Highland unaffected with an output of 10.Devise a table with two rows corresponding to each state (rows marked P and F).In three columns, show income to three portfolios: the portfolio of 100% H cap-ital, the portfolio of 100% L capital, and the portfolio of 50% H � 50% L capital.

Answer: See the following table.

b. Two more states of world appear: Armageddon (A) and Utopia (U). Each happenswith 50% probability but is uncorrelated with the P-F state. Armageddon affectsboth countries equally and lowers income in each country by a further 4 units,whatever the P-F state. Utopia leaves each country unaffected. Devise a table withfour rows corresponding to each state (rows marked PA, PU, FA, FU). In threecolumns, show income to three portfolios: the portfolio of 100% H capital, theportfolio of 100% L capital, and the portfolio of 50% H � 50% L capital.

Answer: See the following table.

S-56 Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization

State 100% L Capital 100% H Capital 50–50 portfolio

P 10 8 9F 8 10 9

State 100% L Capital 100% H Capital 50–50 portfolio

PU 10 8 9FU 8 10 9PA 6 4 5PA 4 6 5

Compare your answers to (a) and (b) and consider the optimal portfolio choices.Does diversification eliminate consumption risk in each case? Explain.

Answer: In (a), Lowland and Highland are each able to eliminate exposure torisk through investing equally in capital at home and abroad. This is because allshocks in this part are idiosyncratic and are negatively correlated. In (b), thecountries are able to reduce some of the volatility in capital income through di-versification, but not completely. This is because both countries are subject tocommon shocks (Armageddon) that cannot be diversified away. This state uni-formly reduces capital income in both countries.

Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-57

S-60 Solutions ■ Chapter 7(18) Output, Exchange Rates, and Macroeconomic Policies

i

Monetary expansion

Fiscal expansion

i1 i1

i2 i2

LM1

IS1

IS2

A

B

Y1 Y2 Y

ER

i

i1 i1

i2 i2

LM1

LM2

IS1

A

B

Y1 Y2 Y

DR2

FR1

DR1

A

B

E2 E1 E$/F

ER

DR2

FR1

DR1

A

B

E2 E1 E$/F

The situation in 2009–2010 was very different. The Fed had exhausted its monetarytoolkit. Keeping their interest rate target at zero meant the economy was at the zerolower bound (in a liquidity trap). Under these circumstances, the job of reviving theeconomy falls to fiscal policy. In December, 2010, a tax bill was passed by Congress,providing a two-percentage-point reduction in the payroll tax for a year, extendingBush tax cuts and unemployment compensation benefits. However, these are all tem-porary measures. We should not expect this bill to have the same punch as permanentchanges in taxes. And, because of the deep recession, the U.S. current account deficitfor 2009 was about half its 2005 level. Under these circumstances, the United States(and most other countries) did not pay much attention to the current account. Theywere properly concerned with reviving their domestic economies.

2. Suppose that American firms become more optimistic and decide to increase invest-ment expenditure today in new factories and office space.

a. How will this increase in investment affect output, interest rates, and the currentaccount?

Answer: This is an exogenous increase in investment demand. This leads to anincrease in the demand for goods, shifting the IS curve to the right. This leads toan increase in output and the interest rate. The increase in the interest rate im-plies an appreciation in the Home currency that decreases the current account.This is illustrated in the following figure.

Solutions ■ Chapter 7(18) Output, Exchange Rates, and Macroeconomic Policies S-61

D

Exogenous increase in investment demand

D1

D2

D Y

A

B

Y1 Y2 Y

i

i2

i1i1

i2

LM1

IS1

IS2

A

Y1 Y2 Y

ER

DR2

FR1

DR1A

B

E2 E1 EH/F

B

b. Now assume that domestic investment is very responsive to the interest rate sothat U.S. firms will cancel their new investment plans if the interest rate rises.How will this affect the answer you gave previously?

Answer: If investment is very responsive to the interest rate, then this impliesthat when interest rates rise, investment will decrease by a larger amount. For anygiven change in the interest rate, investment will change by a larger amount, im-plying the IS curve is flatter. Therefore, for a given exogenous increase in invest-ment demand, the effect on output will be smaller. This is illustrated in the fol-lowing diagram. The original shift in the IS curve shown in (a) is the dotted line.Note that the horizontal shift in the IS curve is the same—this is the exogenousincrease. However, the effects on output, interest rates, and the current accountare smaller compared with (a).


D

D1

D2

D Y

A

B

Exogenous increase in investment demandwhen investment demand is interest elastic(more sensitive to change in interest rates)

Y1 Y2 Y

ER

DR2

FR1

DR1A

B

E2 E1 EH/F

i

i1 i1

i2

i1

i2

i2

LM1

IS1

IS2

A

Y1 Y2 Y

B

3. For each of the following situations, use the IS-LM-FX model to illustrate the effectsof the shock. For each case, state the effect of the shock on the following variables(increase, decrease, no change, or ambiguous): Y, i, E, C, I, and TB. Assume the gov-ernment allows the exchange rate to float and makes no policy response.

See the following figures.

a. Foreign output decreases.

Answer: IS shifts left, DR shifts down: Y ↓, i ↓, E ↑, C ↓, I ↑, TB ↑


i

i1

i2

i1

i2

LM1

IS1IS2

A

B

Y2 Y1 Y

ER

DR1

DR2

FR1

A

B

E1 E2 EH/F

Question 3a

b. Investors expect a depreciation of the Home currency.

Answer: FR shifts right, IS shifts right, DR shifts up: Y ↑, i ↑, E ↑, C ↑, I ↓, TB ↑

i

i1 i1

i2 i2

LM1

IS1

IS2

A

B

Y2Y1 Y

ER

DR1

DR2

FR1

FR2

A

B

E2E1 EH/F

Question 3b

c. The money supply increases.

Answer: LM shifts right: Y ↑, i ↓, E ↑, C ↑, I ↑, TB ↑

i

i1 i1

i2 i2

LM1

LM2

IS1

A

B

Y2Y1 Y

ER

DR1

DR2

FR1

A

B

E1 E2 EH/F

Question 3c

d. Government spending increases.

Answer: IS shifts right, DR shifts up: Y ↑, i ↑, E ↓, C ↑, I ↓, TB ↓


ER

DR2

FR1

DR1A

B

E2 E1 EPar/Br

i

i2

IS1

LM1

LM2

i1

i2

i1A

B

Y2 Y1 Y

LM1i

i1

i2

IS1

IS2

A

B

Y2Y1 Y

i1

i2

ER

DR1

DR2

FR1

A

B

E1E2 EH/F

Question 3d

4. How would a decrease in the money supply of Paraguay (currency unit is the“guaraní”) affect its own output and its exchange rate with Brazil (currency unit isthe “real”). Do you think this policy in Paraguay might also affect output across theborder in Brazil? Explain.

Answer: A decrease in the real money supply leads to a leftward shift in the LMcurve. This leads to a decrease in Paraguay’s output, an increase in Paraguay’s interestrates, and an appreciation in the guaraní. This is illustrated in the following figure. Thiscould affect output in Brazil through the trade balance. First, because Paraguay’s in-come is lower, Brazil’s exports could decline. Second, because the real has depreciatedrelative to the guaraní, this may make Brazilian exports more attractive to foreigners,potentially boosting Brazil’s trade balance. The overall effects on Brazil’s trade balanceand its output are ambiguous.At the same time, Brazil’s economy is more than 15times the size of Paraguay’s. Therefore, the impact of a change in Paraguay’s monetarypolicy on Brazil’s economy is likely to be small. (Source: International MonetaryFund, World Economic Outlook Database, October 2009.)


5. For each of the following situations, use the IS-LM-FX model to illustrate the effectsof the shock and the policy response. Note: Assume the government responds by us-ing monetary policy to stabilize output, unlike question 3, and assume the exchange rateis floating. For each case, state the effect of the shock on the following variables (in-crease, decrease, no change, or ambiguous): Y, i, E, C, I, andTB.

See the following diagrams. Point B is identical to the outcomes shown in question 3.Point C shows the outcome when monetary policy is used to stabilize output.

a. Foreign output decreases.

Answer: IS shifts left, LM shifts right to stabilize Y: Y no change, i ↓, E ↑, C nochange, I ↑, TB ↑

i

i1

i2

i3

LM1

LM3

IS1IS2

A

B

C

Y2 Y1 Y

ER

i1

i2

i3 DR3

DR2

DR1

FR1

A

B

C

E2 E3 EH/FE1

Question 5a

b. Investors expect a depreciation of the Home currency.

Answer: FR shifts right, IS shifts right, LM shifts left to stabilize Y: Y no change,i ↑, E ↓, C no change, I ↓, TB ↓

c. The money supply increases.

Answer: LM shifts right, then LM shifts left to stabilize Y: No change in Y, i, E,C, I, or TB. Here, the money supply shock is annulled by the central bank.

i

IS2

LM3

LM1

i1

i2

i3

i1

i2

i3

IS1

A

B

C

Y2 YY1

ER

FR2

DR1

DR2

DR3

FR1

A

B

C

E1 E2 EH/FE3

Question 5b

i

i1

i2

LM1

LM2

IS1

A C

B

Y2Y1 Y

ER

i1

i2

FR1

DR2

DR1A C

B

E2 EH/FE1

Question 5c

d. Government spending increases.

Answer: IS shifts right, LM shifts left to stabilize Y: Y no change, i ↑, E ↓, C nochange, I ↓, TB ↓


i

i1

i2

LM3LM1

IS1IS2

A

B

C

Y2Y3 Y1 Y

i1

i2

ER

FR1

A C

B

E1 E2 EH/F

DR1

DR2

Question 6a

6. Repeat the previous question, assuming the central bank responds in order to main-tain a fixed exchange rate. In which case or cases will the government response bethe same as in the previous question?

See the following diagrams. Point B is identical to the outcomes shown in Question 3.Point C shows the outcome when monetary policy is used to fix the exchange rate.

Answer: IS shifts left, LM shifts left to keep E fixed: Y ↓, i and E no change, C ↓, I no change, TB ↑

i

i1

i2

i3LM1

LM2

IS1

IS2

A

C

B

Y2Y1 Y

i1

i2

i3

FR1

DR2

DR3

DR1A

B

C

E2E3 EH/FE1

ER

Question 5d

Answer: FR shifts right, IS shifts right, LM shifts left to keep E fixed: Y ↑, i ↑, E nochange, C ↑, I ↓, TB ↓

i

i1

i2i3 i3

LM3 LM1

IS1

IS2

A

B

C

Y2Y3Y1 Y

i1

i2

ER

FR1

FR2

A

B

C

E1E2 EH/F

DR1

DR3DR2

Question 6b

Answer: IS shifts right, LM shifts right to keep E fixed: Y ↑, i and E no change, C ↑, I no change, TB ↓


Answer: LM shifts right, then LM shifts left to keep E fixed: No change in Y, i, E,C, I, or TB. Here, the money supply shock is annulled by the central bank.

i

i1

i2

i1

i2

LM1

LM2

IS1

A = C

B

Y2 YY1

ER

FR1

A C

B

E1 E2 EH/F

DR1

DR2

Question 6c

i

i1

i2

LM1

LM2

IS1

IS2

A C

B

Y2 Y3 YY1

ER

i1

i2

i3

DR2

DR1

FR1

A C

B

E1E2 EH/F

Question 6d

7. This question explores IS and FX equilibria in a numerical example.

a. The consumption function is C � 1.5 � 0.75(Y � T ). What is the marginalpropensity to consume MPC? What is the marginal propensity to save MPS?

Answer: MPC � 0.75, MPS � 0.25

b. The trade balance is TB � 5(1 � [1/E ]) � 0.25(Y � 8). What is the marginalpropensity to consume foreign goods MPCF? What is the marginal propensity toconsume home goods MPCH?

Answer: MPCF � 0.25, MPCH � MPC � MPCF � 0.75 � 0.25 � 0.5

c. The investment function is I � 2 � 10i. What is investment when the interestrate i is equal to 0.10 � 10%?

Answer: I � 2 � 10(0.10) � 1

d. Assume government spending is G. Add up the four components of demand andwrite down the expression for D.

Answer: D � C � I � G � TB

D � 1.5 � 0.75(Y � T ) � 2 � 10i � G � 5(1 � [1/E ]) � 0.25(Y � 8)

D � 10.5 � 0.5Y � 0.75T � 10i � G � 5(1/E )

e. Assume forex market equilibrium is given by i � ([1/E] � 1) � 0.10, where thetwo foreign return terms on the right are expected depreciation and the foreigninterest rate. What is the foreign interest rate? What is the expected future ex-change rate?

Answer: i* � 10%; Ee � 1 (this is the UIP condition)

b. a strike in france leads to a reduction in french …...solutions chapter 7(18) output, exchange...

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