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Homework 6

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renato.moreira6089
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Homework 6

Macroeconomics I, UC3M

Question 1: Use the model of the small open economy to predict what would happen
to the trade balance, the real exchange rate, and the nominal exchange rate in response to
each of the following events.
1. A fall in consumer confidence about the future induces consumers to spend less and
save more.

2. A fiscal reform which creates incentives to firms to invest in new fabrics.

3. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars
over domestic cars.

4. The central bank doubles the monetary base.

5. The introduction of automatic teller machines reduces the demand for money.

Question 2: Consider an economy described by the following equations:

Y = C + I + G + NX
Y = 5000
G = 1000
T = 1000
C = 250 + 0.75[Y − T ]
I = 1000 − 50r
N X = 500 − 500ϵ
r = r∗ = 5

1. In this economy, solve for national saving, investment, the trade balance, and the
equilibrium exchange rate.

2. Suppose now that G rises to 1250. Solve for national saving, investment, the trade
balance, and the equilibrium exchange rate. Explain what you find.

3. Now suppose that the world interest rate rises from 5 to 10 percent. (G is again 1000.)
Solve for national saving, investment, the trade balance, and the equilibrium exchange
rate. Explain what you find.

Question 3: Consider a small open economy. Suddenly, a change in world fashions make
the exports of the country unpopular.
1. What happens to saving, investment, net exports, the interest rate and the exchange
rate?

1
2. The citizens of the country like to travel abroad. How will this change in the exchange
rate affect them?

3. The fiscal policy makers want to adjust taxes to maintain the exchange rate at the
previous level. What should they do? If they do this, what are the overall effects on
saving, investment, net exports and the interest rate?

Question 4: In 2005, Federal Reserve Governor Ben Bernanke said in a speech: “Over
the past decade a combination of diverse forces has created a significant increase in the global
supply of savings − a global saving glut − which helps to explain both the increase in the
U.S. current account deficit (a broad measure of the trade deficit) and the relatively low
level of long-term real interest rates in the world today.” Is this statement consistent with
the models you have learned? Explain.

Question 5: You read in a newspaper that the nominal interest rate is 12% per year in
Sweden and 8% per year in the United Kingdom. Suppose that the real interest rates are
equalized in the two countries and that purchasing power parity holds.

1. Using the Fisher equation, what can you infer about expected inflation in the United
Kingdom and in Sweden?

2. What can you infer about the expected change in the exchange rate between the
Swedish Krona and the United Kingdom’s Pound?

3. A friend proposes a get-rich-quick scheme: borrow from a United Kingdom bank at


8 percent, deposit the money in Sweden at 12 percent, and make a 4 percent profit.
What’s wrong with this scheme?

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