192 Econ. Midterm Exam October 29, 2002 Part I. True/False (60 points) Answer 6 of the following 8 questions. State whether each statement is true or false. Then briefly explain you answer in 2 or 3 lines. You may use graphs as you see fit, but they are not required. Each question is worth 10 points. 1. Imports of goods and services into the United Kingdom create a supply of foreign exchange and demand for pound sterling in British foreign exchange markets. False. Imports of goods and services create demand for foreign exchange as British citizens require foreign exchange to purchase the imports. It creates a supply of pounds as they offer pounds to buy the foreign exchange. 2. If the price level in the UK increases at a faster rate than in the US, the US dollar will appreciate, all else being equal. True. The relative increase in the price level in the UK makes British goods relatively more expensive. The quantity of pounds supplied at a given exchange rate will be higher i.e., the supply curve shifts right from S0 to S1, as imports to the UK increase. The quantity of pounds demanded at a given exchange rate will fall, as exports from the UK decline i.e., the demand curve shifts left, from D0 to D1. This means the exchange rate falls, or the value of the dollar increases.
$/L S0 S1
e0 e1 D0 D1 Quantity of pounds
3. The US international investment position declined dramatically in the 1980's and the US became the world's largest debtor due to the very large current account deficits it experienced during that period. True. The US ran large and persistent current account deficits through the 1980s. These were offset by large inflows of foreign capital. Within a couple of years, the US went from the world's largest creditor to the largest debtor.
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4. In the simplest Keynesian model, an increase in government spending leads to an increase in output by an amount less than the increase in government spending. False. Government spending leads to an increase in output that is greater than the increase in government spending. The difference is the Keynesian multiplier 1/(1-b), where b is the marginal propensity to consume, adjusted for the marginal propensity to import. 5. A small country's balance of payments (in millions of dollars) is as follows: Imports ..................................................1,000 Exports ................................................... -950 Net public and private capital flows ........ -25 Official settlements balance..................... -25 This implies the country's central bank is intervening in foreign exchange markets to maintain a fixed exchange rate. True. The central bank's intervention is reflected in the official settlements balance of 25. The intervention is intended to make the balance of payments zero, and to stop the exchange rate from changing. (Note: if you answered false, but argued that the bank is intervening to limit the exchange rate adjustment i.e., it is not a fixed rate, but a managed float, which requires central bank intervention you get full credit.) 6. The US federal government recently reported that the nation's water and wastewater systems will need to spend more than $80 billion over the next 20 years, over and above current levels of investment, to maintain the nation's drinking water and wastewater infrastructure (water and sewer mains, treatment plants, etc.) This increased investmentmuch of it by the government sectorwill lead to an increase in the US current account deficit, all else equal. True. In the Keynesian model, the increase in investment (or, if you wish, the increase in government spending to pay for the infrastructure) means spending is greater than production, so inventories fall and output rises. The rise in output leads to a rise in imports, which leads to a decline in the current account balance. As the US now runs a current account deficit, this is an increase in the deficit on the current account. (Note: the BoP may, in fact, be in surplus along the way as a result of this change due to a larger increase in the balance on the capital account. Eventually, the BoP becomes zero. But the current account deficit will be larger, and the capital account surplus will be larger.)
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i
LM
FE' FE
IS' IS" IS Q* Q'
Q
7. The yen is trading at a 5 percent premium in the 360 day forward market. (I.e., the yen is trading at $0.0099 in the current spot market and at $0.0104 in the 360 day forward market). If US interest rates are 5 percent and Japanese interest rates are 3 percent, investors should purchase dollar denominated assets. False. Note: i$ - i 2% < < (ef-e)/e 5%
Therefore, investors should purchase yen-denominated assets. 8. Divergences between the forward premium or discount and interest rate differentials between countries reflect actual or threatened restrictions on the ability to move money across borders. When capital controls are not in place, the covered interest parity condition tends to hold true. True. This is a true statement, as explained in you text. Empirical evidence tends to support the covered interest parity condition; when they are divergences, it is usually in the face of capital controls. Part II. Essay (40 points) Over the past 25-30 years, China has gradually liberalized its economy (in other words, it has allowed the use of markets to allocate resources rather than a planning). central This has led to substantial foreign direct investment, contributing to a dramatic increase in manufacturing, and to the country's remarkable economic development and growth. Please answer each of the following questions about the impact of these changes on the country, using graphs as necessary. State any assumptions you feel are necessary to answer the questions. Label all graphs clearly. Each question is worth 10 points. 1. Using the simplest Neoclassical model, demonstrate the impact of the increase in the capital stock generated by the foreign direct investment. What does the model predict the impact to be on output, employment, and the real wage in China? What steps lead to these changes? 3 of 6
The increase in the capital stock shifts the production function and associated demand for labor curve up. The change in the capital stock from K0 to K1 (where K1>K0) increases output from Q* to Q' in the following graph,. Wages get bid up to (w/p)' from (w/p)*. Output, employment, and the real wage all increase.
Q Q(K1)
Q'
Q(K0) Q*
(Nd)*
MPL
Nd
Ns
(w/p)'
MPL(K1)
(w/p)*
MPL(K0) (Nd)*
Nd
The next day, the capital stock is higher, and GDP, employment, and the real wage are unchanged. Firms have more capital but the same number of employees, so the marginal product of labor is greater than the real wage. They try to hire additional workers, which bids up the wage. The wage increases until the demand for labor equals its supply. Due to the higher productivity associated with the increased capital stock, output increases. 2. What would you expect the balances on the current and capital accounts to be after the liberalization of the economy began? Would you expect these balances to change as the economy develops? If so, how would they change, and why? If not, why would they remain unchanged? As China begins liberalization and foreign investors begin to invest in the country, you would expect the current account to be in deficit. The deficit is offset by the surplus in the capital account arising from the inflow of foreign capital. As production increases in the country, it will begin exporting goods and services and paying off investors. So we would expect the current account deficit to decline and eventually become a surplus, and we would expect the capital account surplus to decline and eventually become a deficit. This assumes capital is allowed to cross borders (China has capital controls). [Note:
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students do not need to make this last point. If they argue capital controls will limit changes in capital account, they get full credit (assuming they discuss the impact of the inflow on the current account.] 3. The early success of the liberalization policy and the regime's continued commitment to it has increased the confidence of investors in China's markets. What effect would this increase in Io have on output, disposable income, consumption, investment, interest rates, demand for money, employment, exports, imports, and the exchange rate? Describe the steps that lead to these changes. This question requires the next simplest Keynesian model (the IS/LM/FE model). The increase in investor confidence is an increase in Io. In the following graph, this is reflected in a rightward shift in the IS curve to IS'. At the new intersection of IS and LM, the country is running a surplus, so the supply of foreign exchange exceeds its demand, driving down the exchange rate. This shifts IS left as exports fall, and it shifts the FE curve left as a higher interest rate is needed at each level of output to keep the balance of payments at zero. The net result is an increase in output (Q), disposable income, consumption, and investment. The interest rate increases (despite the rise in investment!). Employment rises, due to the rise in output, from (Nd)* to (Nd)'. Exports fall, imports rise, and the exchange rate falls. Demand for money does not change.
i
Q
LM i' i*
FE' FE
Q' Q*
IS' IS" IS Q* Q'
Q
(Nd)*
(Nd)'
Nd
4. What impact do you think this growth in China's economy would have on the US economy? Is this development good or bad for the US? This is an open ended question. If the answer is based on sound economic principles, it gets full credit. On the plus side for the US, the growth in China's output leads to a growth in income, which will lead to a growth in their imports. Some of these imports will be from the US. Also, some of the investors are from the US, so presumably they are earning a good return on their investment. Therefore, the rise in China's income should have a positive impact on the US economy.
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Gains from trade argues this should be good for the US, to the extent it increases specialization and trade. This is important and is beyond the scope of this class (although students are free to mention it). On the negative side of the ledger, some sectors in the US may be hurt those that compete with Chinese imports. This also is a microeconomic issue that is the subject of international trade and beyond the scope of this class. There are political ramifications as well. If China's economic liberalization leads to further political liberalization, which presumably will benefit the US (as well as China). On the other hand, the benefit to the US and China is called into question if slave and/or prison labor is used in the manufacture of exports.
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