Chapter 13

Question 6: Can you think of reason why a government might be concerned about a large current
account deficit or surplus? Why might a government be concerned about its official settlements
balance (that is, its balance of payments)?

Answer: A current account deficit or surplus is a situation which may be unsustainable in the long
run. There are instances in which a deficit may be warranted, for example to borrow today to
improve productive capacity in order to have a higher national income tomorrow. But for any perio
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of current account deficit there must be a corresponding period in which spending falls short of
income (i.e. a current account surplus) in order to pay the debts incurred to foreigners. In the
absence of unusual investment opportunities, the best path for an economy may be one in which
consumption, relative to income, is smoothed out over time.

Question 7: Do data on the U.S. official settlements balance give an accurate picture of the extent

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to which foreign central banks buy and sell dollars in currency markets?

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Answer: A foreign asset in the form of foreign currency or foreign bond held by the central bank
of United States (The Federal Reserve) is regarded as the official international reserves. The net

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changes in the transactions (buying or selling) of these official international reserves by the
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Federal Reserve in private asset markets to affect the macroeconomic conditions in United States
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is shown by the official settlements balance of United States. But, the official settlements balance
of United States does not give an accurate picture of foreign central banks transactions of dollars
in the currency market. If a central bank of foreign country buys or sells dollars in the currency
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market, it would not appear in the official settlements balance of the United States rather will
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appear in that of the foreign country.

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Chapter 15:

Question 1: What are the main factors that determine aggregate money demand?
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Answer: Three main factors: interest rate, the price level, and real national income. A rise in the
interest rate causes each individual in the economy to reduce her demand for money. If the price
level rises, individual households and firms will spend more money than before. When real
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national income (GNP) rises, the demand for money will rise.
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Question 2: Explain how the money markets of two countries are linked through the foreign
exchange market.

Answer: In order to see how the money markets of two countries are linked through the
foreign exchange market we can look at the price of Euros’ in terms of dollars. A strengthening
of the dollar today relative to its given expected future level makes the euro deposits more
attractive by leading people to anticipate sharper dollar depreciation in the future. More so, a
country’s equilibrium interest rate is determined in its money market. For example, the US
money market determines the dollar interest rate, which in turn affects the exchange rate that

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 maintains interest parity. Similarly, the link between the European money market and the foreign
exchange market operates through the changes in the euro interest rate. Finally, the U.S. and
European central banks determine their money supplies. Given the price levels and national
incomes, equilibrium in national money markets leads to the dollar and euro interest rates. Then,
these interest rates feed into the foreign exchange market.

Question 3: Explain- without using graphs- the exchange rate over-shooting hypothesis.

Answer: Is a theoretical explanation for high levels of exchange rate volatility. The key features
of the model include the assumption that goods’ prices are sticky, or slow to change, in the short
run, but the prices of currencies are flexible, that arbitrage in asset markets holds, via the
uncovered interest parity equation, and that expectations of exchange rate changes are
“consistent”: that is, rational. The most important insight of the model is that adjustment lags in
some parts of the economy can induce compensating volatility in others; specifically, when an
exogenous variable changes, the short-term effect on the exchange rate can be greater than the
long-run effect, so in the short term, the exchange rate overshoots its new equilibrium long-term

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value.

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Chapter 16:

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Question 1: Explain Purchasing Power Parity and why it is expected to hold.
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Answer: As long as the law of once price holds then PPP must hold because it’s the movement in
exchange rate between two countries currency by changes in price levels and if one price holds
which states that’s identical goods must sell for the same price when expressed in the same
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currency then PPP is the same too.

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Question 2: Discuss the differences between Absolute PPP and Relative PPP

Answer: Absolute PPP implies that “a bundle of goods should cost the same in one country and
another once you take the exchange rate into account.” Any deviations from this (if a good is
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cheaper in one country than in another), then we should expect relative prices and the exchange
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rate between the two countries to move towards a level at which the good has the same price in
the two counties. Relative PPP describes differences in the rates of inflation between two
countries. Specifically, suppose the rate of inflation in one country is high than that in the other,
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causing the price of the good in the first country to rise. Purchasing power parity requires the
good to be the same price in each country, so this implies that the first country’s currency must
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depreciate vis-à-vis the other country’s currency. The percentage change in the value of the
currency should then equal the difference in the inflation rates between the two countries.

Question 3: Explain why exchange rate model based on PP is a long run theory.

Answer: PPP theory is a monetary approach to the exchange rate. It is a long-run theory because
it does not allow for price rigidities. It assumes that prices can adjust right away to maintain full
employment as well as PPP

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 Question 4: What can explain the failure of relative PPP to hold in reality?

Answer: Government measures of the price level differ from country to country. One reason for
these differences is that people living in different countries spend their income in different ways.
Because of this inherent difference among countries, certain goods will be affected more by price
changes given their consumptions. For example, consumers in country X, eats more fish relative
to another country. More than likely, the government, upon determining a commodity good to
reflect preference, will have an overwhelming representation of fish. Any price level change in
the fish market will be felt particularly by country X, and their overall price level will reflect
this. Thus, changes in the relative prices of goods components can cause relative PPP to become
distorted.

Chapter 17

Question 1: Explain how does an increase in the real exchange rate affect exports and imports?

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Answer: When the real exchange rate increases, domestic products are cheaper relative to foreign
products. Due to this, exports increase as foreigners demand more of our exports. The change in

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imports is ambiguous because fewer units of imports are purchased (the volume effect), but each
foreign unit is now more expensive (the value effect). Remember: exports and imports are

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measured in terms of domestic output, i.e. dollar value, not volume of units. However, we often
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assume that the volume effect outweighs the value effect, so that imports decrease when the real
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exchange rate rises.

Question 2: What is the real exchange rate?

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Answer: It is the purchasing power of a currency relative to another at current exchange rate and
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prices. It is the ratio of the number of units of a given country’s currency necessary to buy a
market basket of goods in the other country, after acquiring the other country’s currency in the
foreign exchange market, to the number of units of the given country’s currency that would be
necessary to but that market basket directly in the given country.
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Question 3: Give 4 examples of situations that would cause the DD-Curve to shift to the left.

Answer: A decrease in government spending, an increase in taxes, a fall in investment demand, a

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price increase, which would lower next export demand, a fall in foreign prices, an autonomous
fall in consumption demand, a shift to demanding more foreign goods at the expense of domestic
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good demand.

Question 4: Give 3 examples of situation that would cause the AA-Curve to shift to the left

Answers:

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 Question 5: Imagine that the economy is at a point on the DD-AA schedule that is above both AA
and DD and where both the output and asset markets are out of equilibrium. Describe how the
economy will reach equilibrium.

Answer: The excess demand for domestic currency leads to an immediate fall in the exchange
rate from E2 to E3. This appreciation equalizes the expected returns on domestic and foreign
deposits and places the economy at point 3 on the asset market equilibrium curve AA. Bust since
point 3 is above the DD schedule, there is still excess demand for domestic output. As firms raise
production to avoid depleting their inventories, the economy travels along AA to point 1, where
aggregate demand and supply are equal. Because asset prices can jump immediately while
changes in production plans to take some time, the asset markets remain in continual equilibrium
even while output is changing. The exchange rate falls as the economy approaches point 1 along
AA because rising national output causes money demand to rise, pushing the interest rate
steadily upward. (The currency must appreciate steadily to lower the expected rate of future
domestic currency appreciation and maintain interest parity.) Once the economy has reached
point 1 on DD, aggregate demand equals output and producers no longer face involuntary

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inventory depletion. The economy therefore settles at point 1, the only point at which the output
and asset markets clear.

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