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ps6_sol - Department of Economics University of California...

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Department of Economics University of California, Berkeley Fall 2008 econ 182 Solutions to Problem Set 6 True, False, Uncertain (a) The financing of US stimulus plan should increase the US current account deficit. True. Because the shock is transitory. (b) Under the flexible exchange rate regime, a permanent fiscal expansionary policy is more effective in boosting economic activity than a transitory one. False. A permanent fiscal policy is ineffective boosting economy output. (c) A country needs to depreciate its real exchange rate to improve its current account. False. It is not a necessary condition. An increase in savings or a decrease in investment are alternative ways to improve the current account without a depreciation. DD-AA Diagram and J-curve It is sometimes observed that a country’s current account worsens immediately after a real currency depreciation and begins to improve only some months later, contrary to the assumption we made in deriving the DD curve. If the current account initially worsens after a depreciation, its time path has an initial segment reminiscent of a J and therefore is called the J-curve. When the current accounts response to the exchange rate follows a J-curve, the DD curve might be negatively sloped in the short run, though the absolute value of its slope would probably exceed that of AA. Use this modified diagram to examine the short-run effects of both temporary and per- manent monetary expansion and fiscal expansion. Monetary expansion: A temporary monetary expansion while depreciating the currency, would reduce output in the very short run. This is shown by a shift in the AA curve to AA’ and a movement in the equilibrium point from 1 to 2. The output would decline because the real depreciation now has a negative effect. A permanent monetary expansion will shift the AA curve out more to AA” due to an increase of E e , and exchange rate overshooting. The output will fall even more. 1
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Department of Economics University of California, Berkeley Fall 2008 econ 182 Fiscal expansion: The effects of a temporary fiscal expansion, depicted as a shift in the output market curve to DD’, would not be altered since it would still expand output and appreciate the currency in this cause (the equilibrium point moves from 1 to 2). Note that there
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