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ANSWER SCHEME TEST 2 ECO 557 QUESTION 1

BM/JUNE 2012/ECO537/557

a)

What is natural rate unemployment? Explain why monetarist believes that expansionary monetary policy will affect output and employment only in short run but not in long run. (10 marks) OCT 2010 BQ4b Defn : unemploy at level (1m) Diagram phililps curve in SR & LR (2m each) Defn PC : curve showing ve r/ship between inflation & unemp (1m) In SR : when MS, Q, unemp , inflation , moving along PC, shows trade off between inflation & unemp (2m) In LR : PC shifts upward to the right, unemp returns to the natural rate but at higher inflation, PC becomes vertical (2m) By using an IS and LM curves, illustrate the monetarist view about the relative effectiveness of monetary and fiscal policy. (10 marks) APR 2011 BQ4a IS flat, investment & AD sensitive to changes in r (2m) LM steep, interest elasticity of money dd is low (2m) Diagram FP (IS to the right) (2m) Shows that in Y is smaller than in r (1m) MP (LM to the right) (2m) Shows that in Y is larger than in r (1m) QUESTION 2 Define rational expectation and by using diagrams, show what happened to output and employment when government did expansionary monetary policy. Differentiate the effect between anticipated and unanticipated of increase in money supply. (20 marks) Defn : expectations based on all available relevant info fwd looking (2m) Eg : Pe depends on MSe, GSe, Te, Ie, other ss side factor such as oil P (2m) Anticipated (diagram 4m + explain 4 m) Diagrams Figure 11-2 pg 231 Govt announced the changes If MS, AD, if AS constant, Q, P, ddL (less than AD), if ssL constant, employ L expect inflation will happen, ssL, AS, P, ddL Effect: Q & employ back to origin BUT at higher P & w Unanticipated (diagram 4m + explain 4 m) Diagrams Figure 11-2 pg 231 BUT no in ss curve Monetary surprise Not affect ssL Q & emp Result = Keynes & Monetarist

b)

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QUESTION 3

BM/JUNE 2012/ECO537/557

a)

During financial crisis 1997, government decided to peg ringgit to the US dollar to overcome the recession. Explain why this happened. Few years later, Malaysia has adopted a new type of exchange rate system. Explain on this new type of exchange rate system. (10 marks) APR 2010 BQ5a Why pegging (5m) By early 1998, ER increased to RM4.40 per USD, a depreciation about 50% because of speculative attack which perceived that RM was overvalued & ripe for a devaluation. The speculators dump RM in forex mkt to avoid losses if RM value actually decreased. This actvt & destabilizing effects leads to instability & investors start to lost confidence in Malaysia economy. The import bills start to increase as foreign goods become more expensive. New type (5m) Current : managed float (RM fluctuates within a basket & monitored by the central bank) Govt allow RM to float freely but time to time try to stabilize the ER Govt will only intervene if there was undue volatility BUT preferred to rely on market factors to determine the value Msia diversify into other currencies BUT pegged to USD to make it vulnerable tu the fluctuations of the dollar Discuss two (2) advantages each of fixed and flexible exchange rates. (10 marks) APR 2011 BQ5b (any 2 each type) Adv of fixed ER (2.5m X 2) Create stability as it creates a stable atmosphere for foreign investment Investors always know his investment value dont have to worry about daily fluctuation Provide greater certainty for exporters & importers with less speculative actvt (if ER is flexible, always fluctuate) Exert strong discipline on domestic firms & employees to keep their costs under control in order to remain competitive in international market Adv of flexible ER (2.5m X 2) Fluctuations in ER can provide automatic adjustment for BOP deficit if deficit, ER will depreciate, P of export falls & P of import will rise, hence reduce deficit Govt has flexibility in determining r r does not have to be set to keep the value of ER within pre-determined bands, govt can set r for domestic econ purposes rather than to achieve given ER target Domestic currency will not be under or overvalued coz will quickly adjust towards will automaticallay adjust for any deficit or surplus in BOP Govt can leave the market forces to look after for BOP & concentrate on obj to develop econ & achieve FE MP can be independent of external influences as there is no need to keep official reserves to finance BOP deficit or to support ER deficits will be corrected without losing any official reserves Insulation foreign foreign shocks (recession) others problem cannot cause deficit as R will adjust to reach new

b)

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QUESTION 4

BM/JUNE 2012/ECO537/557

a)

Differentiate between three (3) exchange rate regimes, namely as flexible, fixed and managed float. (10 marks) Flexible (3m) No govt intervention Self auto to correct deficit/surplus ER will appreciate/depreciate Fixed (3m) Fixed ER below Use reserve to overcome deficit Effect : will run pout reserve in LR Managed float (3m) + 1 extra mark Contain elements of flexible & fixed ER is allowed to move in response to mkt forces Central bank will only intervene to prevent undesireable movement in ER Briefly explain four (4) propositions that characterize the monetarist position. (10 marks) Ms (by central bank) is the dominant influence on nominal Y (econ actvt) In SR, Ms influence Q & employment (bcoz P not fully adjusted) In LR, money influence P level only, NOT Q & employment Q determined by I, in stock, L, tech Private sector stable (HH & firm are shock absorbing & self adjusting) BUT govt policies instable (eg: govt control Ms, policy, P, min w, r) (2.5m x 4)

b)

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