Economics 181

Homework #3

1. Suppose that due to the widespread introduction of debit cards in Germany, there is a permanent fall in money demand. Use a graph of the money and foreign exchange markets and the AA-DD graphs to show the short run and long-run effects on the German economy. Discuss results, particularly the impact on the interest rate, nominal exchange rate, and output.

2. Suppose that Japanese firms become more optimistic about the prospects for coming out of their recession in the near future, and they decide to increase investment expenditure today in new factories and office space.

  1. Use the AA-DD curves to discuss the short-run effects of this temporary rise in investment on Japanese output, interest rate, real exchange rate, and current account. (Assume that in this case investment is not a function of the interest rate.)
  2. Suppose now that investment is responsive to the interest rate, so that Japanese firms will cancel their new investment plans if the interest rate rises. How will this affect the story you told in part a?

3.In order to keep the dollar from devaluating against the yen, the U.S.’s central banks could intervene by selling yen and buying dollars. However, the pool of currencies in the marketplace is much larger than most government’s holdings.

On one side, it seems unlikely that market intervention from some of the world’s most economically influential countries would even have much impact on the currency markets, due to the vastly large amount of currency that is traded every day. On the other hand, just the stated intention of a large country’s central banks to intervene in the currency markets could disrupt the market entirely due to its psychological effects.

  1. Do you agree that since the amount of currency traded every day is so immense, that it is impossible for even some of the largest countries in the world to influence their country’s exchange rates?
  2. Describe how just a country’s stated intention to intervene could have a psychological effect on the exchange market.

4. Suppose that Malaysia decides to fix its currency, the ringgit, to the Japanese yen at a rate of 22 yen per ringgit. Later Malaysia finds itself facing a balance of payments (more precisely, Official Settlements) deficit of 5 billion yen. Discuss the effects of this deficit on Malaysia’s money supply and the level of foreign assets held by its central bank when

  1. Any foreign exchange intervention is sterilized.
  2. Any foreign exchange intervention is unsterilized.
  3. Under this situation, would the Malaysian currency have been stronger or weaker if theMalaysian central bank had not intervened in the market for foreign exchange?

5. Consider the case of France following World War II. It is beginning a temporary period of expansionary government spending as it rebuilds its damaged infrastructure. And it is considering whether to join the Bretton Woods system of fixed exchange rates.

  1. Suppose first that France undertakes its temporary expansionary fiscal policy while maintaining a flexible exchange rate. State the short-run effects of the fiscal policy on France’s output, exchange rate, and current account, using the AA-DD-XX graph to show this.
  2. Suppose instead that France fixes its exchange rate and then undertakes the temporaryexpansionary fiscal policy. State the short-run effects on France’s output, exchange rate, and current account, using the AA-DD-XX graph to show this. Explain each curve shift. Compare the result to your answer in part (a).