Practice Questions Short Answer Questions. PROVIDE BRIEF ANSWERS. A1.

The natural level of output is the level of output that occurs when the goods market is in equilibrium. Evaluate briefly. A2. In an open economy if imports are equal to exports, then we know that the government budget is balanced. Evaluate briefly. A3. Assume that the interest parity condition holds. Also assume that the U.S. interest rate is 4% while the U.K. interest rate is 6%. Given this information, should we the UK pound to appreciate or depreciate by 2%? Why? A4. In the Phillips curve equation, a rise in the actual inflation rate causes an upward movement along the curve whereas an increase in the expected inflation rate causes an upward shift in the Phillips curve. Briefly evaluate.

Comprehensive Questions B1. Assume that a hypothetical economy is currently in a long run equilibrium situation. Also assume the SAS is represented by the LUCAS relationship (upward sloping). (a) Using an AD/AS diagram, show the effect of a negative demand shock caused by a drop in the consumers confidence on real GDP, the price, interest rates, and jobs in the short run. (b) Now assume that in response to the effects of this shock the domestic Central Bank of is considering the following two options:

(i) (ii)

A hands off (do nothing) policy, An active counter-cyclical monetary policy to restore full employment quickly.

Show in your diagram how the economy will be expected to adjust to each of these policy options. Do each separately. B2. Identify two industries (sectors) that might end up benefiting from the countrys currency depreciation and two industries (sectors) that might wind up suffering from the same. Provide details and defend your answer fully. B3. Suppose that the federal government reduces its spending (G) and at the same time reduces taxes (T) by the same amount. Also suppose the economy is currently operating below full employment and that prices are constant. (a) (b) Show, using an IS/LM diagram, the impact of the spending cut on the interest rate, real GDP, I and C. Now show, using the same diagram or separately, the impact of the tax cut of the

(c) (d)

same magnitude on the interest rate, real GDP, I and C. Keeping in mind the fiscal multipliers, discuss the net impact of the combination of these policies in part (a) and (b) on the economy. What is the effect of this contractionary fiscal policy, (a) plus (b), on the budget deficit and debt?

B4. (a) Explain carefully how the countrys central bank conducts an expansionary monetary policy. Make sure you discuss all aspects of this policy including the mechanism, tools, etc. Your answer should also include a diagram. (NOTE: DO NOT explain how this policy impacts the economy.) (b) Now discuss how the Central Banks actions in part (a) impact the economy (the transmission mechanism of monetary policy). (c) Using appropriate diagram(s) discuss how each of the following assumptions would affect the effectiveness of monetary policy-as conducted above- in changing the real GDP in the short run? i) ii) Investment is very sensitive to the interest rate. The SAS curve is very steep.

B5. Consider the table below

CPI (% change) (annual rate) Latest Currency Units per US dollar ($) Year ago

Canada (C$)

2.5 1.58

1.57

U.S. ($)

2 -

euro ()

1.8 1.13

.99

a) Calculate the actual rate of change of the exchange rate. ( C$/$, /$ ) (From last to this year).

b) What are the predicted rates of exchange for C$ and based on purchasing power parity theory? c) Based on your answers to (b), which currency is overvalued/undervalued, and by how much? What should happen to C$ and euro in the future? Why? Answer a) E^ = (1.58-1.57)/1.57 = 0.64% , and E^ = (1.13-.99)/.99 =14.14% b) Predicted (implied by PPP): E^ = 2.5-2 = 0.5% for C$, and E^ = 1.8-2. = -.2% for euro. c) C$ should have depreciated by 0.5% according to the theory, but it has depreciated by more, 0.64%, and euro should have appreciated according to PPP but it has actually depreciated. Therefore, C$ and euro are both undervalued, (.64 - .5 = .14 %) and ( 14.4 (-.2) = 14.6% respectively, and should appreciate according to PPP. Since the predicted rate of change in C$ is 0.5 --> it should've depreciated from its previous year's value of 1.57 to 1.57 +0.005 (1.57) = 1.57785 (compared to 1.58) and euro should have appreciated by = -2% from its previous level of 0.99 to 0.99 - 0.002 (0.99) = 0.98802 (compared to 1.13.)