PS 4 with Answers - METU Department of Economics Econ 202...

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1/8 METU Department of Economics Econ 202 Macroeconomic Theory Spring 2010 Problem Set 4 with Answers (Chapters 18 – 19 – 20) Q.1 Suppose that the exchange rate is fixed at 10 TL per dollar even though the current exchange rate implied by the market mechanism is 15 TL per dollar. Annual demand for and supply of TL are given as:  ??? ± ? and  ??? ² ?? where E is the exchange rate defined as TL per $. a) Do the signs make sense? Explain. Do these functions back up the market exchange rate of 15TL per dollar? Note that E is defined as TL per dollar. As E increases, TL becomes cheaper vs. dollar. Thus as E increases, demand for TL increases. Hence the positive sign in demand function. Similarly, as E increases, TL becomes cheaper and its supply falls. Thus the negative sign in supply function. Solving the demand and supply functions together for the equilibrium interest rate yields E=15; hence given functions support market price. b) (No numbers required) Suppose investors owning a lot of bonds denominated in TL suddenly start paying attention and decide to sell out into dollars. What would this do to the currency? How can domestic authorities move the interest rate to convince investors to stay a little longer? What effects would this have on the economy? At 10 TL per dollar, there is excess supply of TL. In other words, TL is overvalued. Devaluation may cure this imbalance (or the imbalance may bankrupt the fixed exchange rate regime). Devaluation would cause foreign investors in TL to incur losses. Fearing devaluation, foreigners move out of TL bonds, buy dollars and run. This would cause TL supply to increase (shift in supply curve) and E would increase. That is, TL would start losing value vs. dollar. In order to persuade foreign investors to remain, government may offer higher returns on domestic government bonds; that is, government tries to cover the risk premium of foreign investors. This, however, would cause investment to be crowded out as interest rates rise in the economy. Available investment resources (domestic and foreign saving) are hoarded into government bonds. Q.2 Consider the following situation. A country is running a large trade deficit, and the policy maker wants to reduce it while not affecting aggregate output. The exchange rate is flexible. You may assume that the Marshall-Lerner condition is satisfied, that there is no J-curve effect, that the domestic and international prices are fixed and equal and that the country allows capital to flow in or
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2/8 out without restraint. a) Describe a mix of fiscal and monetary policies which would do the job. The only mix of policies which would work would be contractionary fiscal policy (IS shifts to the left) and expansionary monetary policy (LM shifts to the right), the two balanced in such a way that aggregate output is not affected (the new IS and LM curves intersect at the same Y as before). The
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This note was uploaded on 03/22/2012 for the course ECON 202 taught by Professor Tunc during the Spring '10 term at Middle East Technical University.

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PS 4 with Answers - METU Department of Economics Econ 202...

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