Exercise 04-solution

Exercise Four: Monetary Approach to Balance of Payments and the others1. According to the equation (4.24), find out the (short-run) effect of the following cases on the balance of payment ( overall balance )? Assume that nominal GDP is initially $100 billion. (foreign price level is fixed)1) The central bank decreases domestic credit by 1%.2) Domestic output grows by $1 billion.Answer: the equation (4.24) is C D Y P E R EF ˆˆˆˆˆ*-+=- 1) When the central bank decreases domestic credit by 1%, it means %1ˆ-=C D, then the change of the balance of payment depends on the exchange rate regime. In case a, the exchange rate is fixed, then the FER must increases by 1%, which relates to an improvement of overall balance. In case b, the exchange rate is flexible, then the FER remains and the overall balance is kept because the exchange rate will absorb all the shock.2) When domestic output grows by $1 billion, Y increases by 1%. Also there are two possible scenarios. In the environment of fixed exchange rate, the FER must increases by 1% and then the improvement of overall balance. In case of flexible exchange rate there will be the same result as 1).2. Think of the Monetary Approach to Balance of Payments, the difference in money market (disequilibrium) will result in the Balance of Payments. So the balance ofpayments could be expressed as the function of the gap between the actual current money supply, M, and desired (long-run) money, M d . And M d is proportional to nominal GDP. PY vM M M FER d d 1),(=--=∆δ 1) Using BP to represent the balance of payments, which is equal to the nominal trade balance in the assumed absence of capital flows, express it as a function of M and PY. What is the effect of ∆M on ∆BP, and why?Answer: The balance of payments is equal toBP = -δ(M -(1/ν)PY)An increase in the money supply will then lead to a balance of payments deficit. This occurs because there is an excess supply of money, some of which is spent abroad.2) Ass ume P=EP*, then what is the effect of a devaluation ∆E, on the balance of payments in the short run? In the long run?Answer: BP = -δ(M -(1/ν)EP *Y)In the short run, ∆BP/∆E = (δ/ν)P *Y > 0, thus a devaluation results in an increase in BP. In the long run, the balance-of-payments surplus means that the money supply isincreasing. Since ∆BP/∆M = -δ < 0, this increase in the money supply reduces BP until BP = 0.3. Multiple Choice.1) Under floating exchange rates, the exchange rate adjusts such that(a) the central bank has met all excess demand or foreign exchange.(b) there is a balance of payments deficit after a devaluation.(c) the economy is at a full employment output level.(d) the central bank must exhaust its foreign exchange reserves.(e) the balance of payments is zero.Answer: (e)2) Which of the following are expenditure-switching policies?(a) Price deflation.(b) Import tariffs.(c) Direct barriers to trade.(d) All of the above.(e) (b) and (c) only.Answer: (d)3) Internal balance is a situation where(a) trade is balanced.(b) output exceeds potential output(c) national savings is zero.(d) output is at the full-employment level.(e) none of the above.Answer: (d)4) The assignment problem refers to the(a) the problem determining whether a policy is expenditure-switching or expenditurereducing.(b) the problem determining whether more output leaks out of an economy through savingsor the trade deficit.(c) the problem determining which part of government, the central bank (with control overthe exchange rate) or the treasury (with control over fiscal policy), is responsible forinternal balance.(d) the problem assigning the cause of a trade deficit as crowding-out or a devaluation.(e) none of the above.Answer: (c)5) The term “sterilization” in the monetary approach to the balance of payments refers to(a) changes in the price level.(b) changes in the money supply.(c) the effects of money supply changes on the exchange rate.(d) central bank actions that prevent reserve changes from altering the monetary base.(e) none of the above.Answer: (d)6) If a country’s international reserves fall by $200 million, and their net domestic assetsincreasesby $100 million, then there will be a change in the balance of payments of(a) $100 million.(b) $200 million.(c) 0.(d) -$100 million.(e) -$200 million.Answer: (e)7) A central bank wishes to sterilize a reserve outflow. Which of the following achieve thisgoal?(a) Expand net domestic assets at the same rate as the reserve outflow is contracting themoney supply.(b) Reduce net domestic assets at the same rate as the reserve outflow is expanding themoney supply.(c) Use open market operations to sell treasury securities on the private market.(d) Use open market operations to reduce domestic money supply.(e) Enlist the help of the fiscal branch to create expenditure-switching activities.Answer: (a)8) In the monetarist small-country model, an exogenous increase in the world price level(a) leads to a higher domestic price level, an increase in domestic money demand and atemporary balance-of-payments surplus.(b) leads to changes in the domestic economy through changes in relative prices as in theelasticity approach.(c) leads to a lower domestic price level, a decrease in domestic money demand and atemporary balance-of-payments surplus.(d) leads to a higher domestic price level, an decrease in domestic money demand and atemporary balance-of-payments deficit.(e) (a) and (b).Answer: (a)。