ss08 - University of Toronto Economics Department...

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University of Toronto Macroeconomics, Theory and policy Masoud Anjomshoa Economics Department Solution set #8 Disclaimer: These solutions are just guidelines for you, and may NOT include a complete solution for the questions and problems in your homework, as you must present in your assignments and/or exams. In your solutions you must show your work, and demonstrate your line of thinking clearly. Please, always check my calculations for unintentional typos or miscalculations. --------------------------------------------------------------------------------------------------------------------------------- 1- a)- Based on Marshal-Lerner Condition, trade balance would improve in response to a depreciation of real exchange rate, i.e. increase in ε , if the export sector is elastic enough to be able to increase, and the import sector should be elastic enough to be able to decrease in response to the depreciation. Therefore, there should be available infrastructure to expand exports; also there enough room to cut back the imports. But how elastic should they be? That is exactly what Marshal-Lerner Condition says: If sum of export and import elasticities is greater than one, then trade balance would improve in response to a depreciation of real exchange rate. b)- The J-curve case is a direct application of above concept. In a very short run, Imports and exports are completely inelastic, and cannot adjust. Therefore, a real depreciation not only does not increase the exports, and decrease the imports, but overall will increase the value of imports and deteriorate the trade balance. ----------------------------------------------------------------------------------------------------------------------------------- 2- Uncovered Interest Parity Relation (UIP): E ) E E ( * i i e - + = a)- i=6% + (1.5-1.5)/1.5 i= 6% b)- 6%=13% + (1.5-E)/E E= 1.6129 Given fixed expected exchange rate, and Canadian interest rate, higher interest rate in the US makes American bonds more attractive, and causes a capital outflow, which leads to an exchange depreciation. Because the new point (i*, E
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ss08 - University of Toronto Economics Department...

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