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Unformatted text preview: Department of Economics University of California, Berkeley Spring 2006 Economics 182 Suggested Solutions to Problem Set 4 Problem 1 : True, False, Uncertain (a) False or Uncertain. In first generation currency crisis models, bad fundamen- tals are the sole source of currency crises. In particular, government policies such as inconsistent fiscal and monetary policies that lead domestic credit to expand are responsible for the inevitable collapse of the fixed exchange rate regime. On the other hand, in second generation models, self-fulfilling speculative attacks are the main cause of crises. Specifically, there may be a range of fundamentals in which the regime is perfectly sustainable if speculators do not attack the currency, and yet in which the regime will collapse if speculators attack. In this case, both the government and speculators are partly responsible for the fall of the regime. (b) False. While it is true that under Bretton Woods the U.S. had some degree of monetary autonomy, ultimately the U.S. was constrained by its commitment to keep the dollar pegged to gold. Because the U.S. was the center country in the monetary system, it was able to undertake expansionary policy to keep the U.S. at full employment and force other countries to follow in order to maintain their pegs against the dollar. In the long run, however, this expansionary policy put upward pressure on the gold price and undermined the Bretton Woods system. (c) True. In general, this statement is true. While there are costs to excessive surpluses, the costs of external deficits are likely to be higher. In particular, deficit countries that are borrowing from the rest of the world often face more acute pressure to reduce imbalances as capital markets become reluctant to continue lending to a deficit country. Moreover, in settings where deficits are financed by central bank selling of reserves, then there is a hard binding constraint on imbalances namely, when reserves run out, adjustment must follow. (d) False. In general, under a fixed exchange rate regime, it is necessary for a country to use both fiscal policy and exchange rate adjustments to achieve both internal and external balance. You should be able to illustrate this in the internal-external balance diagram. The underlying idea is that the country has two objectives internal and external balance and two instruments the exchange rate and fiscal policy. If the country uses only one instrument, say fiscal policy, it will be able to achieve only one of the two objectives. To achieve both objectives, the country must use both instruments. Problem 2: The Gold Standard (a) Changes in parities reflected both initial misalignments and balance of payments crises. Attempts to return to the parities of the prewar period after the war 1 ignored the changes in underlying economic fundamentals that the war caused....
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- Spring '08