chapter 15 - problems

chapter 15 - problems - Chapter 15 QUICK QUIZ 2. Money is...

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Unformatted text preview: Chapter 15 QUICK QUIZ 2. Money is (a) cash only. (b) all deposits at all financial institutions. (c) an asset that can be used directly as a means of payment. (d) another name for wealth. (e) another name for income. (f) another name for purchasing power. 3. In an given year, the real money stock will be greater than the nominal money stock if (a) the price level has not changed since the base year. (b) the price level has risen since the base year. (c) the price level has fallen since the base year. (d) the nominal money stock has risen since the base year. (e) the nominal money stock has fallen since the base year. (f) the nominal money stock has not changed since the base year. 4. The opportunity cost of holding money is measured by (a) the size of the country's nominal money stock. ∙ (b) the size of the country's real money stock. (c) the country's price level. (d) the change in the country's price level. (e) the nominal interest rate. (f) the level of transactions undertaken in the year. 5. When a country's central bank buys government bonds or foreign exchange from the public, (a) the money stock rises but by less than the purchase. (b) the money stock falls but by less than the purchase. (c) the money stock rises by more than the purchase. (d) the money stock falls by more than the purchase. (e) the money stock rises by the amount of the purchase. (f) the money stock falls by the amount of the purchase. 1 6. A decrease in the real money stock (a) causes a movement to the right along the LM curve. (b) causes a movement to the left along the LM curve. (c) causes a shift to the right of the LM curve. (d) causes a shift to the left of the LM curve. (e) causes the money demand curve to shift to the right. (f) causes the money demand curve to shift to the left. 7. The slope of country's BOP curve is determined by (a) the country's GDP. (b) the country's taste for imported goods and services. (c) the exchange rate regime under which the country operates. (d) the degree of capital mobility. (e) the sensitivity of the country's investment to its interest rate. (f) the sensitivity of the country's money demand to income. 8. Under a flexible exchange rate regime, a surplus in the balance of payments will be eliminated by (a) a currency depreciation which shifts the IS and BOP lines to the right. (b) a currency depreciation which shifts the IS and BOP lines to the left. (c) a currency appreciation which shifts the IS and BOP lines to the right. (d) a currency appreciation which shifts the IS and BOP lines to the left. (e) a currency appreciation which shifts the LM curve to the left. (f) a currency appreciation which shifts the LM curve to the right. 9. Under a fixed exchange rate regime, a deficit in the balance of payments will be eliminated by (a) central bank intervention to buy foreign exchange, which raises the money stock and shifts the LM curve to the right. (b) central bank intervention to sell foreign exchange, which raises the money stock and shifts the LM curve to the right. (c) central bank intervention to buy foreign exchange, which lowers the money stock and shifts the LM curve to the right. (d) central bank intervention to buy foreign exchange, which raises the money stock and shifts the LM curve to the left. (e) central bank intervention to sell foreign exchange, which lowers the money stock and shifts the LM curve to the left. (f) central bank intervention to sell foreign exchange, which lowers the money stock and shifts the LM curve to the right. 2 10. Automatic adjustment from a BOP deficit tends to be associated with (a) a rise in Q under a fixed rate regime and a fall in Q under a flexible rate regime. (b) a rise in Q under a flexible rate regime and a fall in Q under a fixed rate regime. (c) a rise in Q under a fixed or a flexible rate regime. (d) a fall in Q under a fixed or a flexible rate regime. (e) no change in Q under a fixed or a flexible rate regime. (f) no change in Q under a fixed rate regime and a fall in Q under a flexible rate regime. ANSWERS TO QUICK QUIZ 2. c. 3. c. 4. e. 5. c. 6. d. 7. d. 8. d. 9. e. 10. b. 3 PROBLEMS AND QUESTIONS FOR REVIEW 1. Consider the role of money in the macroeconomy: (a) What is money? (b) Distinguish between the nominal money stock and the real money stock. (c) Under what conditions, for a given year, will the nominal money stock exceed the real stock? The real stock exceed the nominal stock? 2. Consider the demand for money: (a) Why do economists typically model the demand for real rather than nominal money balances? (b) What are the two major variables on which the quantity demanded of real money balances depends? Briefly explain the link between each variable and the demand for money. 3. Using the model of the foreign exchange market: (a) Explain the effects of changes in the following variables on the current‐account balance: Q*, Q, R. (b) Briefly explain the effects of changes in the following variables on the capital‐account balance: i*, i, Ee. 4. What relationship must hold between the current‐account balance and the capital‐account balance for the balance of payments to be in equilibrium? 6. Consider the relationship between the money stock and the balance of payments under a fixed exchange rate: (a) Briefly explain the process by which a balance‐of‐payments surplus under a fixed exchange rate regime leads to a rise in the domestic money stock. (b) Briefly explain the process by which a balance‐of‐payments deficit under a fixed exchange rate regime leads to a decline in the domestic money stock. (c) Think about the implications of your answers to (a) and (b) for the conduct of activist monetary policy under a fixed exchange rate. Are your conclusions optimistic or pessimistic for discretionary monetary policy? Why? 7. Explain the economic reasoning behind the slopes of the LM and BOP curves. 8. Illustrate the economy's automatic adjustment to a general equilibrium under a fixed exchange rate using an IS‐LM‐BOP diagram. 9. Illustrate the economy's automatic adjustment to a general equilibrium under a flexible exchange rate using an IS‐LM‐BOP diagram. 4 10. Periodically, Japan considers "redenominating" its currency because the yen is such a "small" currency unit (for example, it takes about ¥100,000 to buy a color television and about ¥2,500,000 to buy a new automobile). Would such a "redenomination" have effects equivalent to those of a devaluation of the yen? Why, or why not? 11. Explain the mechanics of the money creation process in an open economy, focusing on differences from the closed economy case. Be sure your. answer includes an equation for the money stock in an open economy and a discussion of the relationship between foreign exchange intervention and the domestic money stock. 5 ANSWERS TO PROBLEMS AND QUESTIONS FOR REVIEW 1. (a) Money is the class of assets. that can be used directly as a means of payment. (b) The nominal money stock is measured in current dollars. The real money stock is measured in the constant dollars of a base year and measures changes in the money stock as if the price level had remained constant. (c) The nominal money stock exceeds the real money stock if the price level has risen since the base year. The real money stock exceeds the nominal money stock if the price level has fallen since the base year. 2. (a) Evidence suggests that individuals choose to hold a certain amount of purchasing power over goods and services rather than a certain number of dollars in the form of money. (b) The quantity demanded of money depends negatively on the interest rate which measures the opportunity cost of holding money (that is, the return on non‐money assets such as bonds). The quantity demanded of money depends positively on income because money is held to make transactions conveniently; and the number and size of transactions undertaken tends to rise with income. 3. (a) Foreign income (Q*) affects the current account positively because a rise in foreign income increases exports. Domestic income (Q) affects the current account negatively because a rise in domestic income increases imports. The relative price of domestically produced goods and services, or the real exchange rate (R), affects the current account negatively because a rise in the relative price decreases exports and increases imports. (b) The foreign interest rate (i*) affects the capital account negatively because a rise in the rate causes a capital outflow. The domestic interest rate (i) affects the capital account positively because a rise in the rate causes a capital inflow. A rise in the expected future spot exchange rate affects the capital account negatively because a rise in the rate (implying an expected depreciation of the domestic currency) causes a capital outflow. 4. For the balance of payments to be in equilibrium, the current‐ and capital‐account balances must sum to zero. 6 6. (a) With a balance‐of‐payments surplus, the quantity supplied of foreign exchange exceeds the quantity demanded. The central bank must purchase the excess foreign exchange by intervening in the foreign exchange market if the pegged exchange rate is to be maintained. The foreign exchange purchased by the central bank becomes part of the stock of foreign exchange reserves, thereby increasing the money stock according to the equation M = mm(GB + FXR). (b) With a balance‐of‐payments deficit, the quantity demanded of foreign exchange exceeds the quantity supplied. The central bank must supply foreign exchange from its stock of reserves if the pegged exchange rate is to be maintained. The reduction in the central bank's stock of foreign exchange reserves reduces the money stock according to the equation in the answer to question 5( d). ∙ (c) The answers to (a) and (b) imply that the central bank must, under a fixed exchange rate, allow the money stock to adjust to a level consistent with balance‐of‐payments equilibrium given the exchange rate. The prospect for discretionary monetary policy (that is, monetary policy in pursuit of other goals) under afixed exchange rate regime is pessimistic. 7. The LM curve is upward sloping. A rise in the interest rate Jowers the quantity of real money balances demanded, requiring a rise in income to raise money demand back to equality with the (fixed) money stock. The BOP curve is generally upward sloping. A rise in the interest rate causes a capital inflow and a capital account surplus, requiring a rise in income to raise imports, bringing about an offsetting current‐ account deficit. There are two important special cases: The BOP curve is vertical if there is no international capital mobility and is horizontal if there is perfect international capital mobility. 7 8. Under a fixed exchange rate regime, the money stock (the LM curve) adjusts to bring about a general equilibrium. From a point of surplus in the balance of payments (for example, point I in the figure below), the foreign exchange intervention resulting from the surplus raises the money stock, shifting the LM curve to the right until adjustment is complete at point Il. From a point of deficit in the balance of payments (for example, point III in the figure), the foreign exchange market intervention resulting from the deficit lowers the money stock, shifting the LM curve to the left until adjustment is complete at point II. 8 9. The balance of payments is in surplus at point I in the figure below. Under a flexible rate regime, the domestic currency appreciates. With fixed domestic and foreign price levels, the relative price of domestically produced goods and services rises, shifting the IS and BOP curves to the left. A general equilibrium is reached when the currency appreciation has shifted the IS and BOP curves to a common intersection such as point II on the LM curve. In the figure below, the balance of payments is in deficit at point I. Under a flexible exchange rate regime, the domestic currency depreciates and the relative price of domestically produced goods and services falls. Both the IS and BOP curves shift to the right as a result of a rise in exports and a fall in imports. A general equilibrium is reached when the currency depreciation has shifted the IS and BOP curves to a common intersection such as point II on the LM curve. 9 10. No, redenomination of a currency doesn't have the relative‐price‐changing effects of a devaluation. This is true for two reasons: First, all prices set in the currency automatically adjust to redenomination. Suppose Japan created a "new yen" equal to 1,000 "old yen." The new‐yen (N¥) price of a color television would be 100, and the new‐yen price of an automobile would be 2,500. Second, exchange rates adjust. If the exchange rate between old yen and dollars is ¥100/$1, the exchange rate between new yen and the dollar would be N¥0.1 0/$1. All prices and exchange rates adjust to the redenomination, so no relative prices are affected. A devaluation, in contrast, alters the relative price of domestic and foreign goods and services as long as P and P* remain fixed. 11. Money is created in an open economy when the central bank purchases either government bonds (through open market operations) or foreign exchange (through foreign exchange market intervention) from the public. The public deposits the central bank check in a commercial bank, and this increase in bank reserves provides the basis for an expansion of the money stockthrough the round‐by‐round process of deposit expansion. Ultimately, the money stock expands by the money multiplier times the size of the central bank purchase. The equation for the money stock in an open economy is M = mm(GB + FXR), and the money stock changes according to ∆M= mm(∆GB + ∆fXR). In a closed economy, the open market operation case is the same, but foreign exchange intervention does not occur. 10 ...
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This note was uploaded on 10/21/2011 for the course ECON 300 taught by Professor Gang during the Spring '06 term at Rutgers.

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