ps5ans - DEPARTMENT OF ECONOMICS S PRING 2006 UNIVERSITY OF...

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Unformatted text preview: DEPARTMENT OF ECONOMICS S PRING 2006 UNIVERSITY OF CALIFORNIA, BERKELEY E CONOMICS 182 Suggested answers to Problem Set 5 Question 1 The United States begins at a point like 0 after 1985, where it is in internal balance but there is a large current account deficit. In the short run, monetary expansion (an upward shift in the point to 1) moves the economy toward the goal of a greater current account surplus, but also moves the economy out of internal balance toward overemployment. The expenditure-reducing policy of reducing the budget deficit (represented by a leftward shift in the point), used in tandem with an expenditure-switching monetary expansion, can restore external balance while maintaining internal balance. Moving the economy into a zone of overemployment puts pressure on the price level, which ultimately reverses the short-run effect of monetary expansion on the real exchange rate by an upward shift in both the II and XX to II’ and XX’ respectively. Question 2 Fiscal expansion in Germany and Japan would have appreciated the currencies of those countries and diminished the bilateral U.S. trade deficits with them, as desired by American officials. On the other hand, monetary expansion in these countries would have worsened the U.S. current account since the dollar would have appreciated relative to the deutsche mark and the yen. Our two-country models suggest that U.S. output would have fallen as a result. (These effects would differ, of course, if the United States altered its policies in response to policy changes in Germany or Japan. For example, if the United States expanded its money supply with the expansion in either Germany or Japan there would be no bilateral effects. If the United States contracted fiscal policy as Germany or Japan expanded fiscal policy there would less of an effect on output in each country.) Question 3 One can construct a matrix analogous to Figure 19A-1 in the text to show the change in inflation and the change in exports for each country in response to monetary policy choices by that country and by the other country. Export growth in a country will be greater, but inflation will be higher, if that country undertakes a more expansionary monetary policy, given the other country's policy choice. There is, however, a beggar- thy-neighbor effect because one country's greater export growth implies lower export growth for the other. Without policy coordination, the two countries will adopt over- expansionary monetary policies to improve their competitive positions, but these policies will offset each other and result simply in higher inflation everywhere. With coordination, the countries will realize that they can both enjoy lower inflation if they agree not to engage in competitive currency depreciation. For example, we can have Foreign Expansionary MP No change Expansionary MP ( ∆ Ex, ∆π ), ( ∆ Ex*, ∆π *) (0.5%, 1%), (0.5%, 1%) (3%, 2%), (0%, 0%) Home No change (0%, 0%), (3%, 2%) (1%, 0.8%), (1%, 0.8%) (1%, 0....
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This note was uploaded on 08/01/2008 for the course ECON 182 taught by Professor Kasa during the Spring '08 term at Berkeley.

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ps5ans - DEPARTMENT OF ECONOMICS S PRING 2006 UNIVERSITY OF...

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