1. Suppose there are two countries in the world and NX for the domestic country is described by NX=150 -5e, where NX is net exports and e is the real exchange rate.
Suppose the domestic real interest rate is 8% and the foreign is 10%.

(a) Assume there are only two periods for this world. Using the intertemporal extrernal balance equation and the exact version of interest rate parity (in terms of the real rate of interest) determine the equilibrium current and future real exchange rate.

(b) Illustrate this solution using a graph

(c) Calculate NX for both periods and for both countries.

(d) Redo (a)-(c) with a domestic real interest rate of 9%. Explain the differences.

2. (a) What happens to the fundamental value of a country's exchange rate when it raises its money supply in a fixed exchange rate system?
Does this make the currency over-valued or under-valued if originally the official exchange rate equaled the fundamental value? Use diagrams.

(b) What happens to the fundamental value of a country's exchange rate when the foreign country raises its money supply in a fixed exchange rate system?
Does this make the currency over-valued or under-valued if originally the official exchange rate equaled the fundamental value? Use diagrams.

(c) If a country wants to maintain its official rate equal to its fundamental value, what must it do when a foreign country raises its money supply?
What happens to inflation?

3. You are given the following information about the economy:

Year 1988    1989     1990  1991
u     .09    .10      .11    .08
Y     1950   1947.5    1855   2255

(a) What was the full-employment level of output each year?

(b) Calculate the growth rate of full employment output each year.

(c) If the expected inflation was .04 for all four years, what was the inflation rate each year?

4. Suppose the reserve-deposit ratio is: res=.5-2i, where i is the nominal interest rate.
The currency-deposit ratio is .2 and the monetary base is 100.
The real quantity of money demand is given by the demand function: L=.5Y -10i, where Y is real output.
Currently the real interest rate is 5% and the economy expects an inflation rate of 5%.
Assume the price level P is equal to 1.

(a) Calculate the money multiplier.

(b) Calculate the reserve-deposit ratio.

(c) Calculate the money supply.

(d) Calculate the value of output Y that clears the asset market.

5. There is a presidential election in the U.S. (a two party country: Republicans and Democrats). Suppose Democrats can persuade firms whether or not to raise prices; Republicans can persuade the Central Bank whether or not to increase the money supply. The Democrats move first. The amount of money a party can raise to finance its campaign, the resulting inflation (pi) and unemployment rates (u) are given below for 4 outcomes (A,B,C and D). What will the outcome of this game be? Explain your reasoning carefully.

                      DEMOCRATIC STRATEGY
             Raise Prices                  Don't Raise Prices

R   r        Outcome A                      Outcome B
E   a        Raise Rep: $40                 Raise Rep: $80
P   i  M     Raise Dem: $60                 Raise Dem: $20
L   s        pi=8%,                         pi=0%,
I   e        u= 8%                          u= 6%
C
A
N

S
T  d  r      Outcome C                      Outcome D
R  o  a      Raise Rep: $20                 Raise Rep: $60
A     i  M   Raise Dem: $80                 Raise Dem: $40
T  n  s      pi=8%,                         pi=0%,
E  o  e      u= 9%                          u= 8%
G  t
Y

6. At the beginning of year one, there is no government debt outstanding. The government runs a $100 billion deficit in year one. Interest at a nominal rate of 10% must be paid starting in year two. Assume nominal GDP in year one is $2000 billion and the nominal growth rate of GDP is 4%. Assume the government balances its primary budget in the future and that the interest rate and growth rate do not change.

(a) What will be the government deficit in years two, three, four and five?

(b) What will be the value of government bonds outstanding at the end of the fifth year?

(c) What will be the debt-GDP ratio at the end of year five?

7. Suppose that for the economy of Xu:

Tax revenue=2000+.1 GDP
Transfers =1500-.05GDP
Government Purchases=3,000
Interest payments=200
Full employment GDP=15,000
Actual GDP=16,000

(a) How much is the budget deficit?

(b) How much is the primary budget deficit?

(c) How much is the full-employment budget deficit?

1. a) e=29.74, ef=30.286
b) see graph 11.B.4 (p.408) in the text.
c)

             Country 1       Country 2
period 1      1.322            -1.322
period 2     -1.43              1.43

d) e=29.87, ef=30.14

  
             Country 1       Country 2
period 1       0.656           -0.656
period 2      -0.715            0.715

Increase in r leads to an increase in the exchange rate which reduces demand for conutry 1's products and therefore the net exports fall.

2. a) An increase in money supply leads to a decrease in the fundamental value of the exchange rate. Whether the currency will be overvalued or undervalued depends on whether the initial money supply was such that the official rate equals the fundamental rate or not. Assuming that it was, the currency is overvalued after the increase in money supply.

b) The FV curve (fundamental value) will shift to the right. The exchange rate is higher for every value of M. (see graph 11.15, p.388 of the text for illustration)

c)It must also raise its money supply (this can be seen on the above mentioned graph). Assuming that the level of output is unchanged, this will lead to an increase in the inflation rate.

3.

------------------------------------------------------------
Year   Unempl.    Y        Yfe     Growth rate     Inflation
                           (a)     of Yfe  (b)        (c)
------------------------------------------------------------
1988    0.09    1950     2074.47       -            -0.02
1989    0.1     1947.5   2116.85       0.02         -0.04              
1990    0.11    1855     2061.11      -0.03         -0.06             
1991    0.08    2255     2348.96       0.14          0 
------------------------------------------------------------

4. a) money multiplier = 2.4
b) res=0.3
c) M=240
d) Y=282

5. Given that Democrats have the first mover advantage they will choose to raise prices since that maximizes the amount of money they can raise given the possible responses of Republicans. The best Republicans can do is to increase M. This will result in 8% unemployment and 8% inflation (the solution is in the upper left corner).

6. a)

----------------------------------------------------------
Period   Primary    Deficit    Debt    Interest     GDP
         deficit
----------------------------------------------------------
1        100         100          0       0         2000
2          0          10        100      10         2080
3          0          11        110      11         2163.2  
4          0          12.1      121      12.1       2249.7
5          0          13.31     133.1    13.31      2339.7
----------------------------------------------------------

7. a) deficit=300 (3000+700+200-3600)
b) primary deficit=100 (3000+700-3600)
c) full-employment budget deficit= 450 (3000+750+200-3500)