ECONOMICS 3200, FALL 2003, ALSTON STUDY GUIDE FOR MIDTERM # 3 (ALSO SEE THE QUESTIONS/PROBLEMS AT THE END

OF EACH CHAPTER) Essay Questions and Answers for Chap 19 1. Explain the law of one price and the theory of purchasing power parity. Why doesnt the purchasing power parity explain all exchange rate movements? What factors determine long-run exchange rates? With no trade barriers and low transport costs, the law of one price states that the price of traded goods should be the same in all countries. The purchasing power parity theory extends the law of one price to total economies. PPP states that exchange rates should adjust to reflect changes in the price levels between two countries. PPP may fail to fully explain exchange rates because goods are not identical, and price levels include traded and nontraded goods and services. Long-run exchange rates are determined by domestic price level relative to foreign price levels, trade barriers, import and export demand, and productivity. 2. Explain the interest parity condition. What key assumption underlies this condition? What factors affect the returns on domestic and foreign deposits? The interest parity condition states that returns on domestic and foreign deposits will be equal. The key assumption for this condition is capital mobility. The return on domestic deposits is equal to the domestic interest rate. The return on foreign deposits is equal to the foreign interest rate minus the expected rate of appreciation of the domestic currency. 3. Explain and show graphically the effect of a decrease in the expected future exchange rate on the equilibrium exchange rate. A fall in the expected future exchange rate shifts RF to the right, causing a depreciation of the domestic exchange rate. RF shifts to the right, from F R1 to R 2F. The equilibrium exchange rate falls from E1 to E2.

4. Explain and show graphically the effect of a decrease in the domestic nominal interest rate due to a decrease in expected inflation on the equilibrium exchange rate. The decrease in expected inflation lowers the domestic nominal interest rate, and increases expected dollar appreciation by more than the fall in the domestic interest rate. Thus, RF shifts to the left by more than RD, causing the domestic exchange rate to appreciate from E1 to E2.

Essay Questions and Answers for Chapter 20 )1 Explain and demonstrate graphically how a purchase of foreign currency reserves leads to overshooting of the exchange rate, and describe the long-run behavior of the exchange rate.

A purchase of foreign assets increases the monetary base and money supply, increasing the price level and decreases the expected appreciation of the domestic currency. The reduction of the expected appreciation of the domestic currency increases the expected return on foreign assets, shifting RF to the right. The domestic monetary expansion lowers interest rates in the short run, shifting RD left, and lowering the exchange rate to E2. As the interest rate returns to its original value, the exchange rate appreciates to E3. This behavior of the exchange rate is overshooting.

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Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed exchange rate system. What alternative policies are available to eliminate the overvaluation of the exchange rate?

As indicated in the graph below, the par value is above the equilibrium value, resulting in overvaluation of the exchange rate. One approach is to pursue contractionary monetary policies, raising interest rates and shifting RD to the right. This process continues until equilibrium at par value is restored. The other alternative is to depreciate the exchange rate.

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Describe and show graphically the situation of a speculative crisis against a fixed exchange rate. What can the central bank do to defend the currency? Indicate this policy graphically. Why might the alternative of devaluation be preferable?

As seen in the graph below, the par value is above the equilibrium value, resulting in an overvalued currency. When the speculative attack begins, the expected depreciation of the domestic currency increases substantially, shifting RF far to the right. Very stringent monetary policy is needed to increase domestic interest rates enough to defend the currency, as RD must shift to R D. The cost to the central bank in terms of 3 the costs of intervention and the contractionary effect on the economy may make devaluation preferable.

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Explain the operation of the gold standard system. What was the required behavior for deficit and surplus nations? What were the implications of this behavior for each nations money supply?

Under the gold standard, each country sets the price of gold in terms of the domestic currency, and the exchange rate is determined by the ratio of these prices. Gold would flow from deficit to surplus nations, reducing the money supply in the deficit nation and increasing it in the surplus nation. The money supply changes would change the price levels in each country in the same direction. Exports from the deficit nation become more competitive due to deflation, while exports from the surplus nation become less competitive due to inflation. These adjustments continued until balance of payments equilibrium was restored. Under the gold standard, nations did not control their money supplies, as gold discoveries and international gold flows determined domestic money supplies. Essay Questions and Answers for Chapter 21 1. Explain and demonstrate graphically how a purchase of foreign currency reserves leads to overshooting of the exchange rate, and describe the longrun behavior of the exchange rate. A purchase of foreign assets increases the monetary base and money supply, increasing the price level and decreases the expected appreciation of the domestic currency. The reduction of the expected appreciation of the domestic currency increases the expected return on foreign assets, shifting RF to the right. The domestic monetary expansion lowers interest rates in the short run, shifting RD left, and lowering the exchange rate to E2. As the interest rate returns to its original value, the exchange rate appreciates to E3. This behavior of the exchange rate is overshooting.

2. Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed exchange rate system. What alternative policies are available to eliminate the overvaluation of the exchange rate? As indicated in the graph below, the par value is above the equilibrium value, resulting in overvaluation of the exchange rate. One approach is to pursue contractionary monetary policies, raising interest rates and shifting RD to the right. This process continues until equilibrium at par value is restored. The other alternative is to depreciate the exchange rate.

3. Describe and show graphically the situation of a speculative crisis against a fixed exchange rate. What can the central bank do to defend the currency? Indicate this policy graphically. Why might the alternative of devaluation be preferable? As seen in the graph below, the par value is above the equilibrium value, resulting in an overvalued currency. When the speculative attack begins, the expected depreciation of the domestic currency increases substantially, shifting RF far to the right. Very stringent monetary policy is needed to increase domestic interest rates enough to defend the currency, as RD must shift to R D. The cost to the central bank in terms of 3 the costs of intervention and the contractionary effect on the economy may make devaluation preferable.

4. Explain the operation of the gold standard system. What was the required behavior for deficit and surplus nations? What were the implications of this behavior for each nations money supply? Under the gold standard, each country sets the price of gold in terms of the domestic currency, and the exchange rate is determined by the ratio of these prices. Gold would flow from deficit to surplus nations, reducing the money supply in the deficit nation and increasing it in the surplus nation. The money supply changes would change the price levels in each country in the same direction. Exports from the deficit nation become more competitive due to deflation, while exports from the surplus nation become less competitive due to inflation. These adjustments continued until balance of payments equilibrium was restored. Under the gold standard, nations did not control their money supplies, as gold discoveries and international gold flows determined domestic money supplies.

Essay Questions and Answers for Chapter 21 Appendix 1. Explain the time-consistency problem. What is the likely outcome of discretionary policy? What are the solutions to the time-consistency problem? With policy discretion, policymakers have an incentive to attempt to increase output by pursuing expansionary policies once expectations are set. The problem is that this policy results not in higher output, but in higher actual and expected inflation. The solution is to adopt a rule to constrain discretion. Nominal anchors can provide the necessary constraint on discretionary behavior. 2. Explain the 1992 crisis that led to the breakdown of the European Unions Exchange Rate Mechanism. What disadvantages of exchange-rate targeting were exhibited during this crisis? The 1992 crisis began with Germany raising interest rates in 1990 to stem inflationary pressures from reunification. This demand shock was immediately transmitted to the other nations in the exchange-rate mechanism. Thus, these countries did not have independent monetary policies and were subject to shocks from the anchor country. This gave rise to the second problem. Speculators bet that these other countries would not want the increased unemployment resulting from the tight monetary policy. Betting that their commitment was weak, speculators bet against these currencies, and a number were forced to devalue or drop out of the ERM. The disadvantages illustrated by this are the lack of independent policy subjecting member nations to shocks from the anchor nation, and the possibility of speculative attacks when commitment is felt to be weak. 3. What are the advantages and disadvantages of inflation targeting?

The advantages are that the policy is clear and simple, that a nation can follow an independent policy with a focus on domestic objectives, that the policy does not rely on a stable money-income relationship, and that the effects of inflationary shocks are reduced. The disadvantages are that success of the policy is difficult to judge due to the lag between policy actions and the ultimate outcome, and that the policy could impose a rigid rule and lead to larger output fluctuations, although these latter two have not proved to be problems in countries with an inflation target. Essay Questions and Answers for Chapter 22 1. Explain the Keynesian theory of money demand. What motives did Keynes think determined money demand? What are the two reasons why Keynes felt velocity could not be treated as a constant? Keynes felt the demand for money depended on income and interest rates. Money was held to facilitate normal transactions and as a precaution for unexpected transactions. For both of these motives, money demand depended on income. People also held money as an asset, for speculative purposes. The speculative motive depends on income and interest rate. People hold more money for speculative purposes when they expect bond prices to fall, generating a negative return on bonds. Since money demand varies with interest rates, velocity changes when interest rates change. Also, since money demand depends upon expectations about future interest rates, unstable expectations can make money demand, and thus velocity, unstable. 2. What factors determine the demand for money in the Baumol-Tobin analysis of transactions demand for money? How does a change in each factor affect the quantity of money demanded?

The factors are real income, the price level, interest rates, and the brokerage cost of shifting between money and bonds. Increases in real income increase money demand less than proportionately, since the model predicts scale economies in transactions demand. Increases in prices increase money demand proportionately, since the demand is for real balances. The quantity of money demanded varies inversely with interest rates, since interest is the opportunity cost of holding money. The brokerage fee is the cost of converting other assets (bonds) into money. An increase in this cost increases money demand. 3. What factors determine money demand in Friedmans modern quantity theory? How does each affect money demand? What determines velocity in Friedmans theory? What effect do interest rates have on velocity? In Friedmans theory, increases in permanent income increase money demand. Increases in the returns on bonds relative to money and the returns on equities relative to money decrease money demand. Increases in the returns on goods relative to the return on money, which is the expected rate of inflation relative to the return on money, decrease money demand. Velocity is determined by the ratio of actual to permanent income. As actual income increases in an expansion, permanent income increases less rapidly, so money demand increases less rapidly than income, and velocity rises (and vice versa for contractions). Interest rates do not affect velocity in Friedmans theory, since the relative returns on money and other assets are predicted to remain relatively constant. 4. In the liquidity trap the demand for money becomes horizontal. Depict this graphically. Demonstrate and explain why increases in the money supply do not affect interest rates, and thus aggregate spending, in the liquidity trap.

The graph should at least have a horizontal line for money demand. There should be an increase in the money supply, which does not change rates when money demand is horizontal. Since monetary policy affects aggregate spending by changing interest rates, aggregate

spending is unaffected. Essay Questions and Answers for Chapter 23 1. Keynes believed that unstable investment caused the Great Depression. Using the simple Keynesian model, demonstrate graphically and explain how a fall in investment reduces equilibrium output. What is the impact on equilibrium output?

A fall in investment shifts the C + I line down in the graph below, from C + I to C + I . Due to the multiplier effect, the fall in output is greater than the fall in investment, as equilibrium output falls from Y to Y .

2. Equal increases in government spending and taxes increase equilibrium output. Explain and demonstrate this graphically. An increase in government spending shifts C + I + G up to C + I + G . Equilibrium output increases from Y to Y . A tax increase shifts the aggregate demand line down by the mpc times the change in taxes, reducing Y to Y . Since the shift due to taxes is smaller than the shift due to the increase in government spending, the net effect is to increase equilibrium output.

3. The Federal Reserve increases interest rates when they want to reduce aggregate demand to fight inflation. How do increases in the interest rate reduce aggregate demand?

Increases in interest rates reduce planned investment. The decrease in investment reduces equilibrium output by a multiple amount due to the multiplier effect. Also, increases in interest rates increase the value of the dollar, reducing net exports, which reduce aggregate demand and equilibrium output by a multiple amount. Essay Questions and Answers for Chapter 24 1. Using the ISLM model, show graphically and explain the effects of a monetary expansion combined with a fiscal contraction. How do the equilibrium level of output and interest rate change? The monetary expansion shifts the LM curve to the right, from LM to LM , and the fiscal contraction shifts the IS curve to the left, from IS to IS . The equilibrium interest rate unambiguously falls, while the effect on output is indeterminate. The graph below shows Y increasing, but that result depends on the way the graph is drawn. Students should know the outcome cannot be determined unambiguously.

2. Using the ISLM model, show graphically and explain the effects of a monetary contraction. What is the effect on the equilibrium interest rate and level of output?

The monetary contraction shifts the LM curve from LM to LM . The result is that the equilibrium level of output falls from Y to Y , and the equilibrium interest rate increases from i to i .

3. Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the demand for money is completely insensitive to changes in the interest rate. What is this effect called? This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve affects only interest rates. The level of output is constant at Y. The fiscal expansion shifts the IS curve rightward, increasing the interest rate from i to i .

4. Show graphically and explain why targeting an interest rate is preferable when money demand is unstable and the IS curve is stable.

Unstable money demand causes the LM curve to shift between LM and LM . If the money supply is targeted, output fluctuates between Y and Y . With an interest rate target, output remains stable at Y. Since the objective is to minimize output fluctuations, targeting the interest rate is preferable.

5. Using the long-run ISLM model, explain and demonstrate graphically the neutrality of money, for the case of an increase in the money supply. The increase in the money supply shifts LM to the right, increasing output to Y , above the natural rate Y*. The interest rate falls from i to i . Excess demand increases the price level, reducing the real value of the money supply. The LM curve shifts back until the all pressure on prices is eliminated by the return to the natural rate of output. The initial and final levels of output and interest rate are the same. No real variables have changed.

Essay Questions and Answers for Chapter 25 1. Using the ISLM model, show graphically and explain the effects of a monetary expansion combined with a fiscal contraction. How do the equilibrium level of output and interest rate change? The monetary expansion shifts the LM curve to the right, from LM to LM , and the fiscal contraction shifts the IS curve to the left, from IS to IS . The equilibrium interest rate unambiguously falls, while the effect on output is indeterminate. The graph below shows Y increasing, but that result depends on the way the graph is drawn. Students should know the outcome cannot be determined unambiguously.

2. Using the ISLM model, show graphically and explain the effects of a monetary contraction. What is the effect on the equilibrium interest rate and level of output? The monetary contraction shifts the LM curve from LM to LM . The result is that the equilibrium level of output falls from Y to Y , and the equilibrium interest rate increases from i to i .

3. Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the demand for money is completely insensitive to changes in the interest rate. What is this effect called? This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve affects only interest rates. The level of output is constant at Y. The fiscal expansion shifts the IS curve rightward, increasing the interest rate from i to i .

4. Show graphically and explain why targeting an interest rate is preferable when money demand is unstable and the IS curve is stable. Unstable money demand causes the LM curve to shift between LM and LM . If the money supply is targeted, output fluctuates between Y and Y . With an interest rate target, output remains stable at Y. Since the objective is to minimize output fluctuations, targeting the interest rate is preferable.

5. Using the long-run ISLM model, explain and demonstrate graphically the neutrality of money, for the case of an increase in the money supply. The increase in the money supply shifts LM to the right, increasing output to Y , above the natural rate Y*. The interest rate falls from i to i . Excess demand increases the price level, reducing the real value of the money supply. The LM curve shifts back until the all pressure on prices is eliminated by the return to the natural rate of output. The initial and final levels of output and interest rate are the same. No real variables have changed.

Essay Questions and Answers for Chapter 26 1. Explain the traditional interest rate channel for expansionary monetary policy. Explain how a tight monetary policy affects the economy through this channel. In the traditional channel, a monetary expansion reduces real interest rates, lowering the cost of capital and increasing investment spending. The increase in investment increases aggregate demand. A monetary contraction has the opposite effect, raising real interest rates, lowering investment and aggregate spending. 2. Explain how expansionary and contractionary monetary policies affect aggregate demand through the exchange rate channel. An expansionary monetary policy reduces real interest rates, causing appreciation of the domestic currency. This depreciation increases net exports and aggregate spending. A monetary contraction increases real interest rates, reducing net exports and aggregate spending. 3. Discuss three channels by which monetary policy affects stock prices and aggregate spending. The answer should include three of the following:

In Tobins q theory, a monetary expansion increases stock prices, increasing the value of the firm relative to the cost of new capital. This stimulates investment in new capital goods, which in turn increases aggregate spending. A monetary expansion increases stock prices, increasing wealth and stimulating consumption and aggregate spending. Expansionary monetary policy increases equity prices. This improves firms balance sheets, reducing adverse selection and moral hazard and increasing lending for investment, which increases aggregate spending. In the household liquidity effect, the increase in equity prices due to a monetary expansion improves consumer balance sheets, reducing the probability of financial distress, and increasing consumer spending on durable goods and housing.

Essay Questions and Answers for Chapter 27 1. Explain and show graphically why continuous monetary growth is needed to generate inflation. Describe how the inflation process is generated. Only continuous monetary growth can cause continuous increases in aggregate demand of the sort needed to generate inflation. Other factors can increase demand and the price level, but none can increase demand continuously. In the graph, the monetary expansion shifts AD to the right. The increase in output above the natural rate increases wages, shift AS to the left. Monetary expansion shifts AD repeatedly, and wages continue to adjust.

2. Explain and show graphically how a tax increase reduces demand and increases unemployment. Why is the speed of the adjustment of wages and/or the role of expectations important in this situation? The tax increase shifts AD down from AD1 to AD2. Output falls below the natural rate to Y1, increasing unemployment. If wages are slow to adjust, the economy remains below the natural rate for a long time, but adjustment back to the natural rate is rapid if wages adjust quickly or if expectations lead to rapid adjustment of wages.

3. Explain and show graphically how a positive supply shock, followed by a more restrictive monetary policy, allows policymakers a painless way to reduce inflation. ANSWER:The positive supply shock shifts the aggregate supply curve to the right, exerting downward pressure on prices. Policymakers can now reduce demand to further reducing inflationary pressure without reducing output below the natural rate. In the figure, prices fall from P0 to P1 due to the positive supply shock, and fall further to P2 due to the reduction in demand.

Essay Questions and Answers for Chapter 28 1. Demonstrate graphically and explain the short-run and long-run effects of an unanticipated monetary expansion in the new classical model. In the new classical model, unexpected monetary expansion shifts AD to the right, as depicted in the figure. Since this is unexpected, the AS curve does not shift, and output increases in the short run. As expectations adjust, AS shifts back and output returns to the natural rate, with only prices rising.

2. Demonstrate graphically and explain the short-run and long-run effects of an anticipated monetary expansion in the new classical model. For anticipated policies, AS shifts with ADS, and real output does not change. The only effect is to increase prices. The economy moves from point 1 to point 3.

3. In the new classical model, show graphically and explain how an expected monetary expansion that is less than expected reduces real output in the short run. What is the long-run result? Demand does not increase as much as expected, so AS shifts to the left more than AD shifts to the right. The result in the short run is a move from point 1 to point 5. In the long-run, AS adjusts to the actual increase in demand, and equilibrium is at point 3, with higher prices and no increase in output.

4. In the new Keynesian model, explain and depict graphically why an expected increase in the money supply increases real output in the short run. What is the long-run result? Although the increase in demand is expected, rigidities prevent AS from shifting as much as AD. Thus, short-run real output increases, as the economy moves from point 1 to point 3. In the long run, with complete adjustment, equilibrium is at point 4, with higher prices and unchanged real output.

5. Explain why anticipated policy has different short-run effects on real output and the price level in the new classical, new Keynesian, and traditional models. What are the long-run effects of anticipated policy in each model? In the new classical model, wages and prices are fully flexible, and expectations are formed rationally. In the new classical model, an anticipated policy changes results in a matching adjustment of wages and prices. Thus, AD and AS shift by matching amounts in the opposite direction. This results in no change in real output, and the largest change in the price level in the short run. In the new Keynesian model, expectations are rational, but rigidities keep wages and prices from adjusting fully even when policy is anticipated. Thus, AD shifts by more than AS. As a result, real output and prices both change, with prices changing by less than in the new classical model. In the traditional model, expectations are formed adaptively, so policy changes do not affect expectations and AS in the short run. Thus, demand changes cause the largest changes in real output, and smallest initial price level changes of any of the three models. In all three models, the long-run result is that real output does not change, and prices adjust fully to changes in demand.