1. Here are Treasury bill rates from 12 November 1996:

Maturity	3-month	6-month	12-month
USA	5.02	5.07	5.20
Canada	2.90	3.06	3.34

The exchange rate between these two countries on the same day was 75.02.
(a) If interest-rate parity holds exactly, what are the market's forecasts for the exchange rate 3 months, 6 months, and 12 months from 12 November? (Hint: Remember that the 3-month interest rate is quoted on an annualized basis; the return given is not the return an investor would get over 3 months.)
(b) How could you test whether your method of forecasting the exchange rate was likely to be successful? (Hint: See page 116 of the textbook.)

2. Japan is experiencing its most severe post-war recession. (You can read about the Japanese government's attempt to end the recession in the textbook on pages 483-484.)
(a) Use the 2-country IS-LM-FE model to describe the effects in North America of a decline in Japanese wealth, which reduces consumption spending in Japan.
(b) Suppose that the Japanese LM curve shifts down and out along the new IS curve, bringing an end to the recession. This occurs because of price adjustment. What would you expect to happen to the real interest rate, inflation, and the nominal exchange rate in Japan as a result?
(c) Use the Bank of Montreal analysis of Japan (from the 222 web page, to the Bank of Montreal link, then `Outlook 97' then Japan) to find out whether the interest rate and the exchange rate in 1994-1995 behaved as you predicted in part (b).

3. Suppose that the expectations-augmented Phillips curve in Canada is given by: pi = pi ^e - (1/3)(u-u ^bar), and that u ^bar = 8. In this question unemployment and inflation rates are given in percentage points.
(a) Tabulate the unemployment and inflation rates for 1990, 1991, and 1992 from the inside back cover of the textbook.
(b) What was expected inflation in each of these three years, if the expectations-augmented Phillips curve given above is correct?
(c) Can you provide any independent evidence about expected inflation in those three years?
(d) How (if at all) could the unemployment costs of the early 1990s disinflation have been reduced?

4. Suppose that statisticians at the Bank of Canada estimate that, as a result of lower interest rates in 1996 than in 1995, banks will hold more reserves. Specifically, suppose that they predict the monetary base will average $4 billion in 1995 and $4.5 billion in 1996.
(a) If the reserve-deposit ratio is 0.125 and the currency-deposit ratio for M1 is 0.75 then what will the values of M1 be in 1995 and 1996? What is the percentage growth rate predicted for M1?
(b) Suppose instead that the currency-deposit ratio is 0.125 in 1995 but that it rises to 0.15 in 1996. (At lower nominal interest rates, households and individuals face a lower opportunity cost of holding currency.) Now what is your prediction for the money growth rate from 1995 to 1996?

5. Consider a strategic game between the federal government and the Bank of Canada. To simplify, suppose that the Bank can set the inflation rate, while the government can set the deficit. Suppose an election is expected and the government would like to increase the deficit. The Bank of Canada generally would like to keep inflation low, but if there is a large deficit it will reluctantly increase the inflation rate to increase seignorage. The game can be described as follows:

		Government
		low deficit	high deficit
Bank	low inflation	B10,G8	B4,G10
	high inflation	B2,G1	B6,G2

In each of the four cells the entries give the value to each party of that outcome. For example, with a low deficit and low inflation the Bank's value is 10 and the government's is 8.
(a) Suppose that the Bank moves first. It is aware of the government's goals and payoffs. What is the outcome of the game?
(b) Can you think of any institutional changes which would bring about an outcome that both parties would prefer?

6. Suppose that the federal Minister of Finance announces a budget which includes a commitment to zero growth in the debt-GDP ratio. Suppose that the current interest rate on government debt is 5% and the growth rate of nominal GDP is also 4%. (Hint: See pages 598 and 600.)
(a) If the federal debt is $500 billion then what should the primary deficit be?
(b) What will be the value of the gross deficit?
(c) What is the effect on the primary and gross deficits necessary for the stable debt-GDP ratio if the interest rate falls to 3%?
(d) By how much would the debt-GDP ratio fall if the primary deficit remained at the value you found in part (a) when interest rates fell?

1.(a) At 3 months the annualized interest differential is 2.12, so the percent appreciation expected in the Canadian dollar is approximately 2.12/4 = 0.53 percent. That gives a forecast of 75.42.
By the same method, the forecast for 6 months out is 75.77. The forecast for 1 year out is 76.42.
( You may get very slightly different answers if you use the exact version of IRP or if you calculate 3 and 6-month returns by `uncompounding' rather than division.)
(b) For the same horizons starting from 13 August 1993 the 3-month rates were 3.05 and 4.40. A year later they were 4.43 and 5.63. Did the Canadian dollar depreciate over the subsequent three months in each case?

2. (a) The Japanese IS curve shifts down and to the left so Japanese income and interest rates fall.
For both reasons, Japanese net exports are predicted to rise. This shifts the North American IS curve down and to the left also, an effect which is enhanced if North American investors also hold wealth in Japan. If prices are sticky, this could have the effect of limiting interest rates and income growth in North America.
(b) From the usual diagram, we expect a fall in interest rates, low inflation (since the economy is to the left of FE) and a fall in the value of the Yen.
(c) All three effects occurred: nominal interest rates fell to 0.50 which means that r fell also unless pi^e changed a great deal; inflation was low or negative; the Yen eventually depreciated against the U.S. dollar.

3. (a) The unemployment rates are: 8.1, 10.3, 11.3. The inflation rates are: 3.1, 2.6, 1.4.
(b) 3.13, 3.36, 2.5. Notice that expected inflation fell more slowly than actual inflation.
(c) Forecaster surveys are one possibility, but the most obvious source is a nominal interest rate. Nominal rates do show expected inflation falling, especially because real rates rose because of the tight monetary policy.
(d) Suggestions to consider might include wage and price controls, added independence for the central bank, reducing payroll taxes, a more gradual disinflation, and announcing the disinflation well in advance (see p 574).

4. (a) 5.14; 5.78; 12.45 percent.
(b) 5.75; 11.86 percent.

5.(a) The Bank knows that whatever value it chooses for inflation the government will choose a large deficit. The Bank therefore chooses high inflation, and the outcome is B6 G2.
(b) One possibility would be for the Bank to be restricted, by the legislation which governs it, to choose low inflation only. Then the government would still choose a high deficit, but at least it would gain more than the bank looses.
A possibility which would make both parties better off would be for the government to move first. If it chooses a high deficit it knows the Bank will choose high inflation, so the government will get 2.
If it chooses a low deficit, it knows the Bank will choose low inflation so the government will get 8. Both prefer this outcome, but the government's inability to comiit itself to a low deficit prevents this being the equilibrium in case (a) when the bank moves first.

6.(a) 0 = (x/500) + 0.05 - 0.04, x= -5
There should be a primary surplus of $5 billion.
(b) The gross deficit will be (-5) + 0.05(500) = 20 billion.
(c) Now they are: 5 (a primary deficit) and 30.
(d) 2 percent (not two percentage points!)