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ECON 200 Problem Set 3 Fall 2007

ECON 200 Problem Set 3 Fall 2007 - Economics 200...

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Economics 200 Macroeconomic Theory Problem Set 3 Due at the beginning of class on September 27, 2007. 1. Find the value of the real exchange rate in the small open economy described by the following equations: ] œ &!!! K œ "!!! X œ "!!! G œ #&!  Þ&Ð]  XÑ M œ )!!  %!< < œ & R\ œ "%!!  &! % . 2. During the 1990s there was a large increase in investment spending by US firms. Analyze the long-run effects on US GDP, investment, interest rates, net exports, and the real exchange rate of an increase in investment opportunities due, for example, to rapid technological progress. 3. Below you will find the text of the article “Caught in the Debt Trap,” from , April 1, 1995, The Economist pp59-60. This article claims that countries with high and rising government debt to GDP ratios will suffer rises in their real interest rates and falls in their real exchange rates. Several mechanisms are advanced to explain this relationship, but we will focus on the increased skittishness of foreign lenders when government debt is high and rising. Using a model of a large open economy, this can be modeled as a rightward shift in the Net Capital Outflow (NCO) curve. Your task is to argue that the large open economy model is appropriate here and then to show that a rightward shift in the NCO curve raises real interest rates and reduces real exchange rates. Write no more than 2 pages including a diagram or two! Caught in the debt trap "After years of unchecked profligacy, spendthrift governments are now being punished by the financial markets" EVER since King Edward III of England defaulted on his debt to Italian bankers in 1335, international investors have fretted about high levels of government indebtedness. They are still fretting today. It is no coincidence that the countries that have seen the biggest falls in their exchange rates in the past year, and the sharpest rises in bond yields, have been those that are the most heavily indebted.
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