ECO2004S-MACROECONOMICS II (2023)

Tutorial 6 (Chapters 17 and 18)

HAND IN DATE: Monday 25th September
Instructions: The tutorial consists of 10 MCQ questions (20 marks) and 3 written type
questions (35 marks).You must answer all questions.

MULTIPLE CHOICE QUESTIONS (2 marks for each correct answer, -0.5 for each incorrect
answer)
1. Which of the following, all else fixed, will cause the real exchange rate to increase?
A) a nominal depreciation
B) a reduction in the foreign price level***
C) a reduction in the domestic price level
D) all of these
E) none of these

2. A tariff is
A) a foreign bond.
B) an order for foreign goods that have not yet been delivered.
C) a barter arrangement between importers and exporters.
D) a tax on imported goods.***
E) a restriction on the quantity of imported goods allowed into the country.

3. For this question, assume the interest rate parity conditions holds. Also assume that the
domestic interest rate is 9% and that the foreign interest rate is 5%. Given this information,
we would expect that
A) Individuals will only hold foreign bonds
B) Individuals will only hold domestic bonds
C) The domestic currency is expected to appreciate by 4%
D) The domestic currency is expected to depreciate by 4%***
E) The domestic currency is expected to depreciate by 9%

4. Because the United States of America traditionally gives more foreign aid than it receives,
the United States of America traditionally has a negative value for
A) The capital account balance
B) The trade balance
C) Investment income
D) Net transfers received***
E) The financial account

5. Suppose a country with a fixed exchange rate decides to reduce the price of its currency.
This change in policy is called
A) An appreciation
B) A depreciation
C) A peg.
D) A devaluation***
E) A revaluation

6. Exports will decrease when there is

A) an increase in the real exchange rate.***
B) an increase in domestic output.
C) an increase in foreign output.
D) all of these
E) none of these

7. Which of the following occurs when the goods market is in equilibrium?

A) Domestic output (Y) equals the demand for domestic goods.***
B) Y equals the domestic demand for goods.
C) Y equals the domestic demand for domestic goods.
D) Net exports equals 0.
E) Demand for domestic goods equals the domestic demand for goods.

8. An increase in domestic demand will have which of the following effects in an open
economy?
A) A smaller effect on output than in a closed economy and a positive effect on the trade
balance
B) A smaller effect on output than in a closed economy and a negative effect on the trade
balance ***
C) A larger effect on output than in a closed economy and a positive effect on the trade
balance
D) A larger effect on output than in a closed economy and a negative effect on the trade
balance
E) None of the above

9. The expression, IM, represents the value of imports in terms of

A) Foreign currency
B) Domestic currency
C) Foreign goods ***
D) Domestic goods
E) Exports

10. Assume the Marshall-Lerner condition holds. Which of the following will cause a
reduction in net exports?
A) A reduction in government spending
B) A reduction in investment
C) An increase in foreign output
D) An increase in the real exchange rate***
E) All of the above
WRITTEN QUESTIONS
Question 1 [10 marks]
Use the information in the table below to calculate what has happened to the real price of
Zambian kwacha in terms of US dollar exchange rate between end-2013 and end-2014. Ensure
that you explain your conclusions.
Zambia USA Zambia USA
Variable End-2013 End-2013 End-2014 End-2014
Consumer 200 100 218 101
Price Index
Treasury bill 9 0.5 12 0.5
rate (%)
Nominal 5.50 kwacha 1 US$ 6.6 kwacha 1US$
Exchange rate
Real Exchange ? ?
Rate

Answer:
Real exchange rate (RER) = E*(P/P*) (3marks)
In 2013: RER= (1 / 5.50)* (200/100) = 0.3636 (2marks)
In 2014: RER = (1/6.6) *(218/101) = 0.3270 (2 marks)
This implies that the RER depreciated between the end-2013 and end-2014 (1 mark). Meaning
Zambian goods are relatively cheaper compared to US goods.(2 marks)

Question 2 [10 marks]

Discuss the following statement: “It’s true that running a current account deficit for a
developing country is a bad thing”
Answer:
No it is not true because it depends on the composition of the current account. Having a current
account deficit means that the value of imports in terms of domestic goods is greater than the
IM/ RER
value of exports. If the value of imports in terms of domestic goods is composed of goods for
consumption purposes only, then running a current account deficit is a bad thing. This means
that the domestic economy will always be in debt given that a deficit implies borrowing from
the rest of the world to finance the current account deficit. This indicates that if interest rates
go up then the economy faces higher interest rate payments without prospects of recovering in
the near future given that the imports are for consumption only.
On the other hand, a current account deficit might mean that investment is greater than saving
(using the equation CA= S-I). If this is the case, then having a current account deficit is not a
bad thing because it means that imports are comprised of capital goods which are used for the
production of other goods. This signals attractive investment climate in the domestic economy.
And that in the near future productivity will improve which in turn will improve the trade
balance. This has the effect of reducing the debt or interest rate payments.
Marking Guideline
• 2 marks for stating: No, it’s not true because it depends on the composition of the
current account
• 4 marks for explaining when it is bad ie consumption purposes only.
• 4 marks for explaining when it is good ie capital goods imported, Investment greater.

Question 3 [15 marks]

Assuming the Marshall-Lerner condition holds and using the ZZ/Y and NX graphs, illustrate
graphically and explain what effect a real appreciation of the domestic currency will have on
output and net exports. Clearly label all curves and explain the dynamics from the initial to the
final equilibrium point.

Answer:
A real appreciation will cause NX to fall (1 mark). The fall in NX will cause a decrease
in demand for domestic goods (1 mark). For given values of output, a decrease in
demand results in output being greater than demand for domestic goods (1 mark). This
then causes output to decrease as producers are not incentivised to produce more given
that demand is low (1 mark). As such, income will decrease which further causes
demand to decrease due to falling consumption spending and investment(2 mark). The
process continues where output will be declining but in smaller magnitudes until a new
equilibrium is reached. Using the ZZ/Y graph, ie diagram (a), initial equilibrium is at
point A where output is equal to Y and demand is represented by graph ZZ1. The
decrease in demand for domestic goods then shifts graph ZZ from ZZ1 to ZZ2. Through
the multiplier effect explained above, equilibrium point will move from point A to point
A’ and output will decrease from Y to Y’. (2 marks).
As Y decreases, imports will decrease as well. However, the decrease in imports will
be less than the fall in exports given that goods in the domestic economy are relatively
more expensive compared to foreign goods. Hence exports will decline. Given that the
Marshall-Lerner condition is holding, it implies that the value of exports will be less
than the product of the quantity of imports and the import bill, thus making the value
of imports in terms of domestic goods to be greater than the value of exports. This has
the effect of shifting the NX curve from NX1 to NX2. At point B there is trade balance
(X = IM) but at new equilibrium, there is a trade deficit of distance CD. (see diagram
b). (3 marks for this paragraph).

4 marks for the correct graphs (2 for graph and 2 for graph b).