Department of Economics
University of California, Berkeley
Suggested Solutions to the Midterm
1. FALSE. An expansionary fiscal policy can affect output under a floating exchange rate
if the expansion is expected to be temporary
. In this case, the DD schedule shifts to the
right and, since expected exchange rate is not affected, the AA schedule does not shift at
FALSE. As Chapter 17 states, with perfect asset substitutability, sterilized foreign
exchange intervention on the part of the central bank will leave the money supply
unchanged, which leaves interest rates, and hence, exchange rates unaffected. With
imperfect asset substitutability, sterilized foreign exchange intervention can affect the
exchange rate, while leaving the money supply and interest rates unchanged.
Suppose that, as in the case of imperfectly substitutable assets, the central bank
sells some of its foreign reserves, but makes a corresponding purchase of domestic assets,
such as government debt. This leaves the money supply and interest rates unchanged.
You should recall that it is the investing public from whom the central bank purchases
domestic assets. Because, as the model in Chapter 17 has it, the stock of the public’s
holdings of domestic government debt has fallen, the riskiness of the public’s collective
portfolio of government debt has declined. This shifts the expected return curve
downward, leading to an appreciation of the currency, even when the money supply has
3. FALSE. The Balassa-Samuelson theory is based on the idea that countries with greater
productivity in traded-goods
sectors should, other things equal, have higher price levels.
Nontradables are assumed to have roughly the same productivity in any country (think of
a haircut). If prices of traded-goods are nearly the same in all countries, higher
productivity in tradables industries in rich countries implies higher wages, higher
production costs, and therefore higher nontradables prices and higher price levels.
4. TRUE. The Balance-of-Payments identity states that the sum of the current account,