ECON 103 PROBLEM SET

1. Consider the zero capital mobility framework. If the economy is in long-run

equilibrium, determine the equilibrium price of domestic goods as a function
of the exchange rate, foreign prices and full-employment income.
2. Draw the aggregate demand curve jointly with an aggregate supply curve.
a. Determine the short-run and long-run equilibria of an economy under
perfect capital mobility and fixed exchange rates. Does long-run
equilibrium require trade balance?
b. Show diagrammatically the short-run and long-run effects of a
reduction in domestic central bank credit, assuming that the economy
is initially in the long-run equilibrium.
c. Describe the short-run and long run impacts of a currency devaluation.
d. Diagrammatically show the effects of an increase in government
spending in both the short run and the long run.
3. Consider an economy under flexible exchange rates and perfect capital
mobility in long-run equilibrium with price stability and full-employment.
Suppose that, owing to increasing labor solidarity and militancy, unions are
able to obtain a sudden 30 percent increase in nominal wage rates.
a. Describe the effects of this disturbance on domestic prices, output,
trade balance; and nominal and real exchange rates. Distinguish
between short-run and long-run effects.
b. What would be the impact of union-led wage hikes if the government
decides to increase the money supply simultaneously. Would this
ameliorate the impact of the wage disturbance on the economy? If so,
in what sense?
4. Suppose the Philippines trades with only the U.S. and the peso freely
fluctuates against the dollar. The Philippines faces perfect capital mobility
with a fixed interest rate i*=0.10. In addition, the Philippines is at fullemployment, with a real level of output equal to 2000 units (in millions of
peso goods). If we assume that the following real money demand function has
been calculated for Philippine residents,

LD 0.20Y 2000i *

and the nominal money supply is currently equal to 600 million pesos:
a. What would be the current equilibrium price of Philippine goods?
b. Assume that you are provided with the following additional
information regarding the Philippines domestic absorption and trade
balance relationships:
A 480 0.78Y 900i *

eP *
0.22Y,
P
where T = 0, e is the peso-dollar exchange rate, P* is the average price
of U.S. goods imported by the Philippines, and P is the price of
Philippine goods. Calculate the current value of the exchange rate on
the assumption that P* = 6.00.
c. Suppose the BSP doubles money supply from 600 to 1200 million
pesos. What would be the long-run equilibrium impact on prices? How
would the peso-dollar exchange rate be affected?
T 490

d. Consider the effects of a rise in the world interest rate from 10% to
15%. What would be the impact on the Philippines output, prices, and
exchange rate?
e. The Philippine government decides to reduce its expenditures on
domestic goods by 40 million units. Assuming the government
expenditures form part of the 480 million autonomous absorption
component in the absorption function A, what would be the
inflationary, output and trade balance effects of the reduced
government spending in the long run? Would you expect the short-run
effects of the policy to be any different?