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Unformatted text preview: DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA, BERKELEY FALL 2007 ECON 182 Solutions to Problem Set 10 Problem 1: Exchange Rate Based Stabilization Between 1980 and 1994, the ination rate in Brazil averaged 823% per year. In 1993, it reached 1928%! In order to get this situation under control, in June 1994, the government implemented an economic stabi- lization program known as the Real Plan. Under the plan, the Bank of Brazil issued a new currency (the Real), and simultaneously fixed its value against the dollar. The following table shows some numbers for Brazil over that period. Year 1993 1994 1995 1996 1997 1998 1999 2000 GDP growth 6.4 5.72 4.9 3.29 4.4 0.38 2.21 4.73 CPI ination 1927.98 2075.89 66.01 15.76 6.93 3.2 4.86 7.04 Real/dollar 0.12 0.85 0.97 1.04 1.12 1.21 1.8 1.95 CA/GDP-0.2-2.6-3-3.8-4.3-4.7-4 US CPI ination 2.95 2.61 2.81 2.93 2.34 1.55 2.19 3.38 a. Suppose that the real interest rates are r BR D r US D 3 % in 1993. Determine the nominal interest rate in Brazil in that year and compare it to the nominal interest rate in the US. Since we assume that r BR D r US D 3 % in 1993, we can calculate the nominal interest rate for Brazil and the U.S. as follows: i BR D r BR C BR D 3 % C 1927 : 98 % D 1930 : 98 % i US D r US C US D 3 % C 2 : 95 % D 5 : 95 % The nominal interest rate in Brazil is much higher than that in the U.S. due to high ination rate in Brazil. b. Assume that nominal interest rates in the US are unchanged in 1994 and 1995. Explain what happens to the nominal interest rate in Brazil after the stabilization program. (the Real was not exactly fixed over that period as you can see from the table, but you can abstract from this here.) Assume i 1994 US D i 1995 US D 5 : 95 % ; then after the stabilization, the nominal interest rate in Brazil should also equal to 5.95%. This is because the expected depreciation term in interest rate parity is zero, i.e. for both 1994 and 1995. c. Explain the drop in the ination rate from 1994 to 1995. The ination dropped because people believed that the government would keep its credible commit- ment of running policies in accordance to the peg of the Real to the USD. d. Calculate the real interest rate in Brazil in 1995. Using the IS-LM diagram, explain why we should observe robust growth shortly after the stabilization. Looking at the table, is this what happened? LAST MODIFIED 5:25PM, 12/06/2007 1 DEPARTMENT OF ECONOMICS UNIVERSITY OF CALIFORNIA, BERKELEY FALL 2007 ECON 182 The real interest rates can be computed in the following way: r 1995 BR D i 1995 BR 1995 BR D 5 : 95 % 66 : 01 % D 60 : 06 % : This means a large monetary expansion, so LM curve will shift to the right, and we would observe...
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