ECON202
HW Assignment #2 (Suggested Answerkey)
Q #s 2 & 9 of Ch. 4 in problems and applications
2. Real interest rate = nominal interest rateinflation rate 11%  inflation rate
Equation of Exchange:
%∆ in Ms + %∆ in V = %∆ in P + %∆ in Y
Or,
%∆ in P
= %∆ in Ms + %∆ in V
 %∆ in Y
Substituting the values, we get as follows:
%∆ in P
= 14% +0% 5% = 9%
Therefore, real interest rate = 11% 9% = 2%
9. The website economist.com is not free resources. The info is available to
paid subscribers only.
However, imf.org has a lot of free resources
including inflation data by country (
www.imf.org
) for comparison. For
example, in 2001 data shows that Turkey had one of the highest inflation
rate (69%) and monetary growth rate (M1 55%, M2 52%) along with
nominal interest rate of 54%. At the same time, the CPI growth rate and Ms
growth rate for the US were 2% and 8% respectively along with nominal
interest rate growth at 2%. These data are fully consistent with the theories
that high inflation economies will have high Ms growth rates and high
nominal interest rates.
Q #s 2, 3, 5, 6, 7, 8, 9, &10 of Ch. 5 in problems and applications
2. a.
S = Y C – G = 5,000 250  0.75(5,0001,000) 1,000 = 750
I = 1,000 – 50 X 5 = 750; (r =r* = 5)
NX = SI = 750 750 = 0
NX = 0 = 500500e; e = 500/500 =1
2.b. S = YC – G = 5,000 250 .75(5,0001,000) 1,250 = 500
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I = 750
NX = S I = 500750 = 250
NX = 250 = 500 – 500e; or e = 750/500 = 1.5
The rise G reduces national saving, but with no change in world real interest
rates, and thus no change in investment. So, I exceeds S and the saving gap
is financed by foreign borrowing causing capital inflow. This transmission
process reduces net exports requiring appreciation of currency. Therefore,
higher G and increasing capital inflow implies higher exchange rate from 1
to 1.5.
2.c. S = YC – G = 5,000 250 .75(5,0001,000) 1,000 = 750
I = 1,000 – 50 X 10 = 500
NX = SI = 750 500 = 250
NX = 250 = 500500e; e = 250/500 =0.5
Increase in world interest rates from 5% to 10% creates capital outflow (by
declining investments), and exchange rates falls to have trade surplus
requiring currency depreciation to 0.5.
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 Spring '08
 AMAN
 Exchange Rate, Inflation, Interest Rates, real exchange rate

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